Topic 1 Topic 2 Topic 3 Topic 4 Topic 5 Topic 6 Topic 7 Topic 8 Topic 9 Topic 10
Globalisation: What and how but for whom? Why are there different explanations of the economic cycle? What is the distinction between short-run and long-run economic growth? Is Inflation targeting a good thing? Why has the availability of credit caused a housing bubble? Will the Quantitative Easing experiment work? Who is the winner in the Euro debate? Are fiscal rules only fiscal folly? Is deflation a false threat? Why does the world economy need to re-balance?
1 11 22 32 44 59 73 89 103 110
Nigel Watson
ISBN: 978-1-905504-57-2
Published by Anforme Ltd., Stocksfield Hall, Stocksfield, Northuberland NE43 7TN. Tel: 01661 844000 Fax: 01661 844111 email: info@anforme.co.uk www.anforme.com
Figure 1 shows the increase in the volume of manufactured goods exported from 2000 to 2008. During this period the volume of goods exported soared. For example, Chinas exports rose from just over $200bn to over $1,300bn per year, an increase of 550% in less than a decade. Germanys export performance has also been impressive too. Germany is the worlds No.2 exporter of manufactured goods. Access to globalised markets has helped companies such as BMW and Siemens to grow. Some economists blame the 1930s depression on Americas decision to impose protectionist trade barriers. Americas trading partners retaliated and the result was a world-wide collapse in trade. As a result countries were forced into becoming more self-sufficient again, and the productivity and output gains previously enjoyed were lost. The credit crunch of 2008 also created an alarming reduction in world trade. Fortunately, policy makers resisted the urge to impose protectionist trade barriers against each other. Trade volumes are now recovering again despite the fact that demand in heavily-indebted countries like Britain and America remains subdued. The demand growth needed to engineer this recovery in world trade has come from consumers in South America and Asia. In July 2010, China became the third largest export market for BMW cars.
It was predicted by the Labour government that fewer than 15,000 people each year would come to the UK from the ex-communist countries that became EU members in May 2004. Instead, an estimated 600,000 migrants came in two years - 62% of them from Poland. Global inequality has always existed; some countries have always been able to offer a higher quality of life for their citizens than others. However, in the past people living in poor countries found it difficult to emigrate due to the immigration policies adopted by richer countries. During the last decade migrants from poorer countries have found it easier to fulfill their ambitions to emigrate because some governments in the rich, developed world have decided to adopt a more relaxed approach towards immigration. In the current political climate people from poorer countries will carry on arriving in Britain as long as British wages and employment opportunities are preferable to those encountered in their home countries. In 2010 there were 63m people living in the UK. The government anticipates that by 2028 immigration will have lifted the UKs population to 70m. However, in Poland, the government is concerned about the economic effects of de-population caused by emigration to Western Europe. Demographers estimate that Polands population will fall by 2.2m by 2035. The economic effect of this change could be considerable because the population of Poland in 2010 was just 38m.
Figure 2, produced by the American Bureau of Labour Statistics, shows that hourly wages in manufacturing are highest in the euro area. In countries like Germany manufacturers overcome the competitive disadvantage of high wage rates by investing heavily in capital, which increases productivity and hence lowers unit labour costs. In addition, firms like BMW and Mercedes do not rely on low costs and low prices for their competitive advantage. Firms like Mercedes sell highly differentiated products that have a price inelastic demand.
Topic 1
In Figure 3, the equilibrium wage in the developed world is initially w1 because at this wage level the supply of labour in the developed world matches the current demand for labour, which is represented by the demand curve DL1. However, in the developing world the equilibrium wage rate is only Wa because the demand for labour is only D1. The price of labour in the developed world is far higher than the price of labour in the developing world. In search of cost savings multinationals have been closing down factories in the developed world, where wages are high, and re-opening them in the developing world, where wages are far lower. This very important aspect of globalisation has led to a narrowing of the wage differential which exists between the developed and the developing world. Factory closures have reduced the demand for industrial workers in countries such as Britain. According to basic microeconomic theory the fall in demand for labour in the developed world from DL1 to DL2 will lead to a fall in the wage rate in the developed world. Manufacturing workers in the developed world will suffer from a wage cut of w1 to w2. The numbers employed in manufacturing in the developed world will also fall from e1 to e2 as a result of this decrease in the demand for labour. At the same time, the decision to transfer production to the developing world will increase the demand for labour in this part of the world from D1 to D2. In the developing world, arbitrage will cause the equilibrium wage to rise from Wa to Wb. The level of employment will also increase from E1 to E2. Theory predicts that the income gap between the developed and the developing world should narrow over time. In the above example arbitrage has reduced the wage differential between the developed and the developing world from (w1Wa) to (w2Wb). The law of one price predicts that arbitrage will continue until wage rates in the developed and the developing world have equalised. International wage arbitrage will narrow the gap in living standards that exists between the developed and the developing world. There is strong evidence to suggest that this process has already begun.
Topic 1
Figure 4: Change in real hourly wages for men by wage percentile, 1973-2007
Source:Lawrence M, Bernstein J, and Shierholz H, The State of Working America, 2008/2009. An Economic Policy Institute Book, Ithaca, N.Y: ILR Press, an imprint of Cornell University Press, 2009
Figure 4 shows that real wages for Americans earning less than the median average wage have fallen since 1973. Many of these workers that earn less than the median average wage have faced growing international competition for their labour. US companies like Nike and Apple have profited from the arbitrage made possible by globalisation. In the past both companies produced their products in US factories. Today, this is no longer true. Both companies now produce in China where wages are a fraction of those paid to US workers. International wage arbitrage has also contributed to the growth of household debt in the developed world. Households in the USA and most of Europe have tried to preserve their living standards in the face of falling real wages by taking on extra debt. Asset bubbles, most noticeably in housing, gave households the confidence to take on the extra debt required to maintain aggregate demand in the USA and Europe.
1. Free trade
The World Trade Organisation and trading blocs such as the EU and NAFTA have promoted globalisation. Removing protectionist trade barriers such as tariffs and quotas has encouraged countries to specialise and trade with each other.
Topic 1
Figure 5 shows how the volume of world trade soared prior to the credit crunch. The growth in world trade has been assisted by politicians who have signed free trade agreements with each other. International organisations like the World Trade Organisation have also worked hard to abolish tariffs and quotas that encourage selfsufficiency, rather than international specialisation. Free trade enabled multinationals to profit from international wage arbitrage. In the last 30 years countries like the US and Britain have exported thousands of manufacturing jobs to countries such as China and India.
Source: www.economist.com/research/articlesBySubject/displaystory. cfm?subjectid=7933596&story_id=10797453 and www.guardian.co.uk/technology/blog/2008/ oct/07/internet.telecoms Crisis Economics: The Cutting Edge Topic 1 7
The bar chart shows how the price of a broadband internet connection has fallen in recent times. Satellite time is also far cheaper to buy. Cheaper communication has helped to spread ideas, information and a global culture. Cheaper communication costs have enabled multinationals to target new markets for their services. Manchester United Football Club is a good example. In 2005 it was estimated that the club had a global fan base of 75m people, which is more than the population of the UK! The American owners of Manchester United, the Glazer family, have tapped into this enormous customer base by selling TV rights and replica football shirts and other merchandising to fans all over the world. In 2009 the club announced a record turnover of over 300m. Much of this turnover would not have been possible without the technological advances needed to screen live games to fans living abroad.
Source: www.economistsview.typepad.com/economistsview/2008/08/globalisation-a.html
In the future more occupations will face competition from low-cost foreign labour. For example, in the past university educated lawyers in Britain and the USA were immune to the threat of outsourcing. However, this is starting to change. According to the New York Times in June 2010, Cash-conscious Wall Street banks, mining giants, insurance firms and industrial conglomerates are hiring lawyers in India for document review, due diligence, contract management and more1. Globalisation: the winners 1. Workers in the developing world have benefitted from international wage arbitrage and outsourcing. Employment levels and real wages in countries such as China and India have increased, lifting the material standard of living. 2. Consumers in the developed world. Globalisation has filled Britains shops with low-priced imported food, clothing and electrical goods. For those still in work, earning an income, globalisation has increased the material standard of living. Those most likely to stay in work are those that perform jobs that have not been outsourced yet. Globalisation: the losers 1. Low-skilled workers in the developed world. Outsourcing has reduced the number of jobs available for UK school leavers. The decrease in the demand for labour created by outsourcing has also limited wage increases. 2. Small businesses in the developing world that lack the economies of scale required to compete against much larger multinationals in a free trading situation.
3. The environment. Globalisation has boosted consumption by keeping prices lower than they otherwise would have been. Lower prices have increased the volume of goods consumed and, 3. Shareholders in companies that have therefore, produced, creating, in boosted their profits via outsourcing. many cases, negative externalities. Globalisation has increased the power of Transporting goods half way around a handful of multinational corporations. the world, rather than producing locally produced goods, also contributes to global warming.
Many of these big businesses routinely employ politicians once their political careers have ended. For example, ex-Prime Minister Tony Blair is paid 2.5m each year by the investment bank JP Morgan. What does Blair know about banking that is worth 2.5m a year to JP Morgan? During Blairs period of office as P.M. was the governments decision-making unduly influenced by the needs and wishes of big business? Do politicians serve the interests of the people who elect them, or the multinationals who pay/bribe/corrupt them?
Globalisation has enabled multinational corporations to profit from wage arbitrage. In search of higher profits companies have closed down factories in high wage countries like the USA and Britain. Production has been transferred to economies such as China, which have lower wage rates. Wage arbitrage has caused unemployment to rise in the developed world, especially amongst the semi-skilled. The fall in the demand for labour created by outsourcing has created stagnant real wages. Many UK households have tried to maintain their living standards by borrowing and become more indebted. On the other hand, in China and India the opposite is true. In these countries employment and real wages are increasing. Globalisation has narrowed the gap in living standards between the developed and the developing world. However, within the developed world globalisation has increased the gap between the haves and the have nots. Economic development is enhanced by democracy. However some economists argue that globalisation has handed the multinational corporations too much power and influence over democratically elected politicians.
1. The EU has helped to create closer economic, political and cultural links between European countries. As such it could be argued that the EU is an agent of globalisation. Explain three benefits of EU membership for British citizens. 2. Globalisation is not a new trend. To what extent do you agree or disagree with this statement? 3. Discuss whether it was a mistake for the developed world to allow China to join the World Trade Organisation in 2001. 4. Should politicians be allowed to take up highly-paid positions with businesses whilst in office, or when they retire? 5. What actions should society take in order to minimise corruption?
Topic 1
10
During this phase of the economic cycle the level of investment crashes because firms no longer need to invest in order to add to capacity. This second fall in the level of investment created by the accelerator will create a second negative multiplier effect. As a result the economy spirals down into a deeper and deeper recession. Economists that believe in the accelerator / multiplier interaction argue that recessions end when firms start investing again to replace worn out machinery. During recession when GDP growth is negative firms will not invest in order to build additional capacity because this extra capacity is not needed. However, it is important to realise that firms also invest to replace worn out machinery. This is the floor level to economic activity. Eventually, even in the depths of recession there will be firms somewhere in the economy that will have to invest to replace a machine that has just broken. When this happens the level of investment in the economy will increase. According to the multiplier theory, an increase in investment will create a final increase in GDP that is many times higher than the value of the initial injection. The increase in national output created by this initial investment injection will increase the rate of economic growth. An increase in the rate of economic growth will create further increases in investment due to the accelerator effect. In addition, secondary increases in investment will also create positive multiplier effects too. According to Keynesians, the accelerator / multiplier interaction should create a sharp re-bound out of recession once the floor in economic activity has been reached.
Topic 2
13
Recessions are prompted by deterioration in the level of business confidence. If confidence falls, firms will expect falling sales in the future. Firms are likely to respond to this expectation by reducing the amount of stock that they hold. To reduce stock holdings firms cut production. For a period, customer demand can be met by running down stocks. The fall in production created by de-stocking, causes employment and output to fall; the economy is likely to slip into recession if firms across the economy react to deteriorating business confidence by cutting production. Robert Peston, the BBCs business editor, was blamed by some people for creating de-stocking, and ultimately, the recession in 20081. According to his critics, Pestons negative reporting damaged business confidence, which led to a wave of de-stocking across the economy. Negative news on the economy also affected the levels of investment too. Firms will tend to postpone investments that add to their capacity if they expect sales in the future to fall. However, few believe that Robert Peston and the rest of the UK media talked the economy into recession. Fluctuations in the level of business and consumer confidence probably do have some influence on the level of economic activity. However, Austrian economists argue that the underlying cause of the UKs recent recession was a contraction of credit. These economists reject the arguments put forward by Keynesians, instead they believe in monetary explanations of the economic cycle.
The increase in demand for assets raises their price, creating a positive wealth effect for the households that own these assets. Feeling richer, households might feel that there is now less need for them to save, creating a further boost to consumption, which lifts economic activity again. Unfortunately, economic booms created by monetary and credit expansions are not sustainable in the long-run. Governments cannot keep on artificially stimulating the economy via fiscal deficits forever because the bond market will eventually question the solvency of the government that wants to permanently live beyond its means. When governments struggle to find buyers for their sovereign debt the boom will be over. To pay down its national debt the government will have to run fiscal surpluses, which remove spending power from the economy, creating a slowdown. Credit expansion in the private sector can also contribute towards a boom. This boom ends when the Minsky moment arrives. According to the American economist, Hyman Minsky, a period of credit expansion ends when households can no longer afford to service their existing debts because they are too high relative to household income2. When the Minsky moment arrives, households begin to default on their debts. At this point commercial banks start to make losses; the amount owed by households that default has to be written off as a bad loss against the banks profits. It is no longer possible for households to take on more debt (to finance new purchases of either asset purchases or consumer goods) because households are already struggling to service the debts that they already have; spending drops and the economy enters the slowdown phase of the economic cycle. The government might try to prolong the boom by delaying the Minsky moment by lowering interest rates. At lower rates of interest a greater stock of debt can be serviced from the same income. (See Topic 10 for further discussion of the Minsky moment). Figure 2: UK interest rates since 1951
Figure 2 shows that UK interest rates have exhibited a downward trend since the 1980s. Falling interest rates have enabled UK households to take on the additional debt needed to sustain UK aggregate demand in the face of falling UK real wages. Interest rates in Britain now stand at just 0.5%. This means that the Bank of England is no longer able to stimulate the economy by interest rate cuts because rates are as low as they can go.
2 www.gsb.stanford.edu/jacksonlibrary/articles/hottopics/business_cycles.html Crisis Economics: The Cutting Edge Topic 2 15
Figure 3 shows the effect that falling interest rates had on UK household debt. Over the last ten years total household debt tripled. The expansion of debt enabled households to purchase goods and services that they could not really afford to buy. The extra demand created by credit fuelled New Labours economic boom. Unfortunately, many UK households are struggling to service their debts because the amount households owe is very high relative to their incomes. According to figures produced by Credit Action in July 2010 the average UK household owes 58,000. This amount of debt is problematic because the median wage in the UK is just 22,000, meaning that households owe far more than they earn in a year. Interest rates in the UK are as low as they can go. However, despite this 185m is spent every day on interest payments by UK households. The Minsky moment can no longer be delayed in the UK. Households are struggling with the debts that they already have. And interest rates are already as low as they can go. The long period of UK credit expansion has almost certainly ended, and with it, high levels of consumer spending (See Topic 5 for further discussion of this concern). According to the Austrian School the recession phase of the economic cycle is caused by a credit contraction. The fall in both the demand and supply of credit leads to a fall in consumer spending, which leads to a fall in aggregate demand and GDP.
Topic 2
16
House prices in Japan rocketed during the 1980s due to a period of credit expansion. Japans property bubble burst in 1992 when credit dried up. House prices in Japan fell for 15 consecutive years. During this time household wealth in Japan also crashed. Households responded by trying to re-build their wealth via saving. A rise in the savings ratio led to a fall in domestic consumption, and in turn, sluggish rates of economic growth.
During credit crunches banks reassess their attitude towards risk. In the past, during the boom, commercial banks, chasing market share, may have underestimated risk, making loans to marginal or sub-prime customers. The losses generated from these failing loans begin to crystallise during the recession as a growing number of households default (declare themselves bankrupt). Banks respond by raising the price of debt, so that interest rates rise. Without government intervention many banks that have made bad loans will fail. Those that are able to survive will have to recapitalise. To attract the cash needed commercial banks will be forced into raising interest rates in order to attract new funds from savers. The banking bailouts of 2008 2009 ensured the survival of banks that had made losses on loans that had defaulted. However, the supply of credit is still restricted because the banks have chosen to hoard most of the bailout cash that they have received. This is probably because the banks realise that most households are already struggling with the debts that they already have. Therefore, in the circumstances, lending more to these households will probably lead to more bad losses at a later date when households subsequently default on these new loans. The banks also realise that interest rates cannot go any lower. In the future, if interest rates rise, the banks could be hit by a fresh wave of losses because higher interest rates will increase the cost of servicing the stock of debt that households already have. Many UK households are already struggling to cope with their debts, even though interest rates are at an all time low. In January 2010 the charity, Shelter, reported that in the last year over 1m UK households had resorted to using their credit card to pay the mortgage or their rent. How will these households cope when interest rates rise? In addition, the banks are also aware of the governments finances and the need for fiscal consolidation. To reduce the rate of growth of the national debt the government will be forced, by the bond market, to raise taxes. Tax increases will reduce the amount of income that UK households have to service their debts. As a result, tax increases are likely to push more UK households over the edge, leading to more personal insolvencies and more bad debts for the banks. In the circumstances, the decision on the part of the UK banks to hoard cash looks to be fairly sensible. Figure 5: Individual insolvencies in England & Wales (thousands, not seasonally adjusted)
Source: Insolvency Service - total individual insolvencies for Q2 2009 onwards include Debt Relief Orders, which came into force on 6 April 2009 Crisis Economics: The Cutting Edge Topic 2 18
Figure 5 shows personal insolvency has soared in the UK since 2000. This has happened because household debt has grown at a much faster rate than household income. As a result many individuals do not earn enough to service the debts that they have built up. In Britain there are three types of personal insolvency: bankruptcy, Individual Voluntary Arrangement (IVA) and Debt Relief Order (DRO). Bankruptcy requires a debtor to sell all of his/her assets to repay the money owed to creditors, such as banks. Any debts that cannot be re-paid are written off. An IVA is an agreement between the debtor and the creditor that enables the debtor to re-schedule their debt repayments. The creditor may also agree to writing-off a part of the debt owed by the debtor. A DRO allows an individual with less than 15,000 of debt and minimal assets to write-off their debts without having been declared bankrupt.
Conclusions
According to monetary explanations of the economic cycle, booms are created by periods of credit expansion. On the other hand, recessions are caused by credit contractions. Unlike Keynesians, Austrian economists that believe in monetary explanations of the economic cycle argue that credit expansions and, therefore, booms can go on for decades. Recessions tend to be equally as long because it will take decades for households and banks to deleverage and repair their balance sheets. Consumer credit is destructive because it destabilises consumer spending. An expansion of credit might lift consumer spending, and hence aggregate demand, for a period. However, spending and economic activity will fall in the period after because the debt taken out during the boom has to be paid back with interest. Consumer credit does not create a permanent increase in economic activity. Instead, credit simply pulls forward spending that would otherwise have occurred in the future. Consumer credit creates debt that can only be repaid by reducing discretionary expenditure in the future. Unlike a commercial investment, borrowing in order to consume does not create an income-bearing asset. For example, a consumer that uses credit to buy a 2,000 flat screen TV can enjoy a product today that they otherwise might not be able to afford. Unlike a firm that borrows to buy a new machine this type of debt will not pay for itself. The TV bought on credit will not create an income stream which will help to pay the interest on the 2,000 credit card bill.
Crisis Economics: The Cutting Edge Topic 2 19
By spending some of tomorrows money today, spending tomorrow falls. When debts are re-paid, spending falls, and the economy slips into recession. Hence Austrian economists argue that it is really the boom that is the problem, not the recession. To prevent recessions the government should avoid fiscal deficits and regulate the banking system to prevent the credit expansions that create the booms. Economies will not suffer from recessions caused by credit contractions if the government acts to prevent booms caused by credit expansions. Governments that try to avoid the consequences of credit contractions by printing money to prop up insolvent banks run the risk of creating hyperinflation. The following quote from Ludwig von Mises neatly sums up the Austrian Schools position, There is no means of avoiding a final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion or later as a final and total catastrophe of the currency system involved.3
The economic cycle describes the fluctuations in economic activity that occurs in all economies in the short to medium term. Economic activity picks up during booms when unemployment falls and economic growth accelerates. During recessions economies contract leading to higher levels of unemployment. Keynesians argue that the economic cycle is best explained by changes in business confidence, which affect the amount of stock held by firms. In addition Keynesians believe that the accelerator-multiplier interaction also contributes to the economic cycle. Austrian economists reject the Keynesian explanations of the economic cycle. They hold the view that economic booms are created by an expansion of credit, whilst recessions are caused by credit contractions. Over the last decade central banks and governments have responded to the threat of recession by using slack monetary policy and expansionary fiscal policy in order to reflate the economy. Austrian economists are critical of this approach. They hold that governments should not intervene to prevent recessions because recessions cleanse the economy of inefficient firms. The factors of production released by firms that have gone into liquidation can then be taken up by more successful firms that would like to expand. In the long-run recessions improve the allocation of resources. Consumer credit destabilises economies. Unlike borrowing to invest, borrowing to consume is not sustainable.
1. Economists have various theories that seek to explain the economic cycle. Which of these theories best explains the 2008-2009 UK recession? 2. UK household debt has exploded since 1990. Explain the role played by debt in creating UK economic growth during the NICE decade. 3. What is the Minsky moment and why is it important? Explain the actions taken by the Bank of England to delay the onset of the Minsky moment. 4. Explain why borrowing to invest is sustainable, whilst borrowing to consume is not. 5. Austrian economists argue that it is the boom that is the problem, not the bust. Explain this view. 6. In 1997 Gordon Brown promised to establish a new economic framework to secure long-term economic stability and put an end to the damaging cycle of boom and bust. Discuss whether it really is possible for policy makers to put and end to boom and bust. To what extent is economic stability desirable?
Topic 2
21
Topic 3 What is the distinction between short-run and long-run economic growth?
Introduction
Economists measure a countrys economic growth rate by calculating the percentage change in real GDP from one year to the next. Economic growth is important to policymakers because growth has the capacity to lift the standard of living within a country, creating economic development. In recent times the economic growth rates of countries in the developed world, like the UK and the USA, have been well below the growth rates achieved by developing countries such as India and China. As a result, in terms of output, the gap between the developing and the developed world has been closing. Figure 1: Chinas rapid growth - real change in gross domestic product (GDP) since 1990, in percent
Source: http://www.spiegel.de/international/world/0,1518,660432,00.html
Figure 1 shows that the economy of China has been growing at a far faster rate than the American economy. National output in China grew by 536% during the period from 1990 to 2009. In the same period the US economy only achieved growth of 61%. Chinas economy is still far smaller than the American economy. However, if China continues to achieve faster rates of economic growth than America the result will be that China will overtake the US economy in terms of its size. Chinas economy is already larger than the UK, French and German economies. According to the World Bank the worlds largest economies in 2009 were:1. USA: 2. Japan: 3. China: 4. Germany: 5. France: 6. UK: 7. Italy $14,256,300 million $5,067,530 million $4,984,730 million $3,346,700 million $2,649,390 million $2,174,530 million $2,112,780 million
To understand why countries like India and China have been achieving higher rates of economic growth than countries like the UK and the USA it is necessary to first of all understand the distinction between short-run and long-run economic growth.
There are two key problems created by this over-reliance on trying to create growth by shrinking negative output gaps. The first problem is relatively easy to identify: the policy is not economically sustainable. It is not possible to keep on creating economic growth by boosting aggregate demand because eventually the economy will run out of spare capacity. For example, in Figure 2 if the economy is already operating at full employment further increase in aggregate demand will create inflation, rather than short-run economic growth. For example, suppose that the economy is operating in equilibrium producing an output level of Y/Fe because aggregate demand is stable at AD3. If the government carries on injecting spending into the economy via continued fiscal deficits and/or further interest rate cuts the increase in aggregate demand created of AD3 to AD4 will only succeed in creating demand-pull inflation of AP2 to AP3.
Crisis Economics: The Cutting Edge Topic 3 23
Increasing demand when the economy is already operating at full capacity will not create short-run economic growth because there is not a negative output gap to close. The second problem created by the desire to chase short-run economic growth is a growing current account deficit. If the economy is already operating at, or close, to full employment additional spending power injected into the economy by the government will suck in imports. Countries like Britain that have lived with current account deficits end up becoming progressively poorer over time. To finance a current account deficit countries have to sell off income-generating assets and/or take on debt from overseas creditors. Britains huge external debts can be traced back in part to the governments and the Bank of Englands decision to pursue short-run economic growth to the exclusion of all else. The governments response to the credit crunch induced recession of 2008-2009 said it all. Apparently the solution to all our problems was more reflationary demand-side policies designed to set the supermarket tills ringing again. Deeper, supply-side issues, such as low levels of investment and productivity in the UK were largely ignored.
It is often said that China and India have relied heavily on an export-led approach towards creating economic growth. This is partially true; per capita incomes in both countries remain very low.
Crisis Economics: The Cutting Edge Topic 3 24
This lack of domestic household demand has been compensated for by exporting output to countries in the economically developed world that have the higher incomes needed to pay profitable prices. However, this is only half the story. Unlike America and Britain, China and India have not relied solely on aggregate demand growth to create short-run economic growth. Instead, both countries have very high levels of saving and investment, which have boosted aggregate supply as aggregate demand has grown, making long-run, noninflationary, economic growth possible. So far both countries have been able to maintain very impressive rates of economic growth because policy makers in both countries have managed to match increased aggregate demand growth with increases in aggregate supply. As a result, the symptoms of overheating, namely demand-pull inflation and growing current account deficits have largely been avoided.
The logic behind this view was simple: banks cannot make loans to their customers if they have no cash in their vaults to lend out! A shortage of loanable funds therefore restricts investment because without saving there cannot be investment. Economists that believed in the Harrod-Domar model argued that in very poor developing countries households might be too poor to save. Low per capita incomes meant that in order to meet basic subsistence needs, nearly every $1 of income earned would have to be spent on life sustaining goods, such as food, water and shelter. The resulting lack of saving in these economies constrained investment, which in turn condemned these countries to a very slow rate of economic growth. Furthermore these poor developing countries faced a classic poverty trap: to lift living standards faster rates of economic growth were required. However, to create faster rates of economic growth the population had to accept the need to save a greater proportion of their income. But, the decision to save more also meant that households would have to sacrifice some of their current consumption. The opportunity cost of a decision to create a faster rate of economic growth would be a fall in consumption in the short-run, leading to a rise in absolute poverty. At that time economists wrote about the dilemma facing developing countries: should developing countries sacrifice their living standards in the short-run, by adopting policies designed to lift the savings ratio, in order to create faster rates of economic growth in the long-run?
Topic 3
26
Source: http://www.statistics.gov.uk/CCi/nscl.asp?ID=5927
There are several reasons that could be advanced to explain Britains low savings ratio: Very low interest rates set by the Bank of England have reduced the financial incentive to save. Savers in the UK face negative real interest rates; the nominal rate of interest is less than the rate of inflation. Those willing to save and postpone consumption are penalised in Britain. Over time, the purchasing power of cash held on deposit in British banks falls over time. In Britain the government taxes interest income generated from savings. The only exception being interest generated from cash held in ISAs (Individual Savings Accounts). To encourage UK households to save more the government could stop taxing all interest income. In Britain the state offers a range of transfer payments, including: job seekers allowance, incapacity benefit and the state pension. These benefits reduce the incentive to save for precautionary reasons. In countries like China the government does not provide a comprehensive cradle to the grave welfare state. Instead, individuals are expected to look after themselves. As a result, households in China are forced into saving more of their income. In the UK the benefits system actually discourages saving. For example, those with substantial savings might not qualify for a free care home, creating a moral hazard. For many UK households, nominal income growth has failed to keep pace with the rising cost of living. Falling real wages make it harder for households to generate the surpluses needed to save. House price inflation in the UK has also soared out of control, leading to higher monthly mortgage repayments. Many people in Britain do not save for a pension because they do not earn enough once housing costs are taken into account.
Topic 3 27
Sadly, many British people have confused mortgage debt with wealth. In countries such as Germany that have managed to avoid property bubbles saving remains high because mortgage debt is lower. Lower rents and mortgage repayments in Germany enable the Germans to save more than the indebted British.
High levels of saving in China have created rapid rates of economic growth
The BRIC countries (Brazil, Russia, India and China) have achieved much faster rates of economic growth than either Britain or America. The reason is simple: unlike Britain and the USA, the BRIC economies do not suffer from a lack of saving and investment. In these countries the government and the people have been willing to sacrifice current consumption to finance saving and investment. High levels of saving have fuelled high levels of investment in the BRIC economies. In turn, these high levels of investment have created spectacular rates of economic growth. Over the last decade households in China have consistently saved 40% of their incomes. Unsurprisingly, China has consistently achieved similarly high levels of investment. Over the same period economic growth in China has averaged 10% per annum, which implies, according to the Harrod-Domar model, that the capital-output ratio in China must be approximately four. 40% (savings ratio) = 10% economic growth 4 (capital-output ratio) Figure 5: Chinese saving and investment, as a % of Chinese GDP
Source: constructed by the US economic think-tank, The Council on Foreign Relations, http://blogs.cfr.org/setser/2009/06/30/the-savings-glut-controversy-guaranteed/
Figure 5, shows the positive correlation between Chinas savings ratio and its level of investment. When the savings ratio rises, the level of investment rises too. According to the Harrod-Domar model saving should equal investment. This is not quite true in China; during the period from 2004 until 2007 saving in China grew, however, the level of investment in China did not. The reason for this discrepancy was that at this time, China was exporting some of its surplus pool of saving to banks and governments in Europe and the USA. The inflow of liquidity into these countries expanded bank lending, creating asset bubbles and rising levels of debt in Europe and the USA.
Crisis Economics: The Cutting Edge Topic 3 28
Chinas decision to export some of its savings to the developed world enabled China to pursue a policy of export-led economic growth. Without access to Chinas savings households in the USA and Europe would not have had access to the credit needed to buy Chinese imports. Figure 6: Growth rates in three countries
Source: http://www.google.com/publicdata/home
Figure 6 compares the rates of economic growth achieved by Britain, the USA and China over the last two decades. China has regularly achieved rates of economic growth in excess of 10%. Sadly, both the US and the UK economies appear to have struggled, achieving growth of less than 5%. Britain and the USA have struggled to grow because they have not saved enough. Low levels of saving mean low levels of investment. This is important because the main factor that creates economic growth in the long-run is investment. Investment boosts GDP by lifting the productivity of a countrys land and labour.
Conclusions
In relative terms the UK looks set to continue its decline against the rapidly-emerging BRIC countries. This decline will only cease when the UK is able to match the rates of economic growth being achieved by these countries. To catch up Britain needs to devote a greater proportion of its GDP to investment. Unfortunately, as a nation we seem to be unwilling to sacrifice current consumption. We remain extremely reluctant to save. But without saving there can be no investment. And without investment, economic growth will remain low. We seem unwilling to give up jam today, for more jam tomorrow. Misguided decisions made by central bankers and governments on both sides of the Atlantic have condemned the USA and the UK to anaemic rates of economic growth. In both countries short-term economic growth has been prioritised over long-term economic growth. British and US policymakers seem to be overly influenced by the Keynesian paradox of thrift. According to Keynes, saving, whilst being an individual virtue, is bad for the economy as a whole.
Crisis Economics: The Cutting Edge Topic 3 29
According to Keynesians, saving should be discouraged because saving reduces consumption. If consumption falls, aggregate demand will also fall too. Falling levels of aggregate demand will cause national output to fall, creating a recession. The problem with the paradox of thrift is that it fails to acknowledge the vital role that saving plays in creating long-run economic growth. The UK and the USA will not grow properly again until they rediscover the need to save. To encourage saving the Federal Reserve and the Bank of England will need to raise interest rates. Whilst there are negative real interest rates on offer for savers, the incentive to save will remain low. Policymakers in Britain and the USA should learn from China: saving and investment create economic growth, not consumption. Finally, much of the investment that did take place in Britain and the USA prior to the credit crunch was wasteful and speculative, and not really worthy of the name investment. In both countries households were allowed to borrow huge sums of money in order to place speculative bets on the price of housing. Sadly, much of this money was wasted, a classic example of what Austrian economists refer to as malinvestment (This is discussed in Topic 5 ).
Topic 3
30
Economists distinguish between short-run and long-run economic growth. Short-run economic growth arises when GDP increases because the economy is now making fuller use of its existing capacity. The most common cause of short-run economic growth is an increase in aggregate demand. On the other hand, long-run economic growth is driven by supply-side factors that increase an economys full employment output level. A good way of creating long-run economic growth is via investment, which increases factor productivity, boosting the economys capacity. In the last decade policy makers in Britain and the USA, obsessed by the paradox of thrift, have underplayed the importance of long-term economic growth, favouring short-run economic growth instead. Interest rates in the UK and the USA have been set too low, which has discouraged saving and encouraged consumption. This policy has helped to boost aggregate demand, creating short-run economic growth. However, low levels of saving have limited the loanable funds available for investment, which has compromised long-run economic growth. On the other hand, in China, where rates of economic growth are much higher, households do save. As a result, banks in China have the finance needed to grant loans to firms that wish to invest. Ironically, given the political system, the Chinese have quite rightly recognised that it is impossible to have capitalism without capital. To create meaningful economic growth countries must save in order to invest. To catch up with the rates of economic growth being achieved by China and India, the USA and Britain must rediscover the merits of saving. However, in order to save more British and US households will have to consume less.
1. Compare and contrast short-run economic growth with long-run economic growth. 2. Explain why the pursuit of long-run economic growth invariably requires a fall in living standards in the short-run. 3. Policy makers in Britain and the USA reacted to the credit crunch by loosening monetary policy. Discuss the possible short-run and long-run impacts of near zero interest rates on the rate of economic growth.
Topic 3
31
2. Financial stability
Financial stability is achieved when commercial banks and other financial institutions are deemed to be reliable and trustworthy. In the past central banks have been responsible for passing banking and other financial regulations that were designed to prevent bank failures. Financial stability is important because banks perform a vital role as financial intermediaries, i.e. they link savers with firms that wish to borrow for investment purposes. In 2007 UK financial stability was compromised by a bank run, culminating in the collapse of Northern Rock. At that time some households responded to UK financial instability by withdrawing their savings, preferring to keep their savings in cash at home instead. This loss of trust in the banks compromised their liquidity, which contributed towards the credit crunch. The Bank of Englands duties no longer extend to maintaining financial stability. In 1997, the then Chancellor, Gordon Brown, set up the Financial Services Authority (FSA) whose role was to regulate the financial sector.
If interest rates fall the unearned income received from cash held on deposit falls. If the savings ratio falls, consumption must rise, because income can only be saved or spent. On the other hand, a fall in interest rates might encourage some households to live beyond their means. Borrowing to consume using personal loans, credit cards and overdrafts becomes cheaper and, therefore, more attractive when the interest rate falls. Lower interest rates will also reduce the cost of servicing existing loans too. The biggest debt that most UK households have is their mortgage. During the period from December 2007 to March 2009 the Bank of England slashed interest rates from 5.5% to 0.5%, which amounted to a 91% fall in the cost of borrowing! Households that had borrowed at variable mortgage rates had their monthly repayments reduced by hundreds of pounds. The additional disposable income created by falling monthly mortgage repayments helped to boost household consumption. Finally, lower interest rates boost consumption because lower interest rates tend to lead to higher asset prices. A good example is the price of housing. Lower interest rates make it cheaper to borrow to buy a house. The additional effective demand made possible by lower interest rates forces house prices up. Higher house prices create a positive real wealth effect for households. Households feel wealthier if their main asset, their home, has become more valuable. Rising house prices add to consumer confidence. House price inflation gave many households the opportunity to go out and borrow more against their appreciating asset. Many UK households gave up saving altogether they viewed their house as their savings.
The margin of error on each side of this central rate is 1%; implying that the Bank must not allow inflation to fall below 1%, or rise above 3%. This is shown in Figure 1. Figure 1: The Bank of Englands Symmetrical Inflation Target
The Bank of Englands symmetrical inflation target implies that the UK government believes that the risks and the associated problems of inflation and deflation are equal. If inflation is expected to rise above 3% the Bank of England is supposed to intervene by raising interest rates now in order to prevent inflation from rising above the ceiling rate. On the other hand, if the Bank of England believes that there is a risk that inflation could fall below the floor level of 1% they should reduce interest rates now to minimise the risk that this could happen. Keynesians believe that low inflation is a threat to the economy. Inflationary pressure, according to the Keynesians recedes when the level of aggregate demand grows slowly. The level of aggregate demand determines the level of output and employment. Sluggish demand growth therefore restrains inflationary pressure at the expense of economic growth. Furthermore, Keynesians also argue that low inflation has a tendency to morph into deflation. An asymmetric inflation target is one that forces policymakers to keep inflation below a certain level set by politicians. Unlike, a symmetrical inflation target there is no lower limit to an asymmetric target. A good example of an asymmetrical inflation target is the European Central Banks target to, keep inflation close to, but below 2%. This target implies that the ECB will respond to the threat of inflation breeching its 2% target. However, unlike the Bank of England, the ECB is under no obligation to react to the threat of low inflation, or even deflation, by cutting interest rates. Figure 2 illustrates the ECB inflation target. Figure 2: The ECBs Asymmetric Inflation Target
The ECB must keep inflation close to, but below 2%. It could be argued that the ECBs inflation target is asymmetric because unlike the Bank of England the ECBs inflation target does not include a floor rate of inflation.
Crisis Economics: The Cutting Edge Topic 4 35
Some Keynesians have put forward the view that the ECBs asymmetric inflation target indicates that this central bank conducts its monetary policy with a deflationary bias. In other words, the ECB is obsessed with keeping inflation low. To maintain low inflation, the ECB will have to set high rates of interest, which will damage economic growth prospects in the Eurozone. This view can be criticised on several grounds. Firstly, the Keynesians have failed to fully comprehend the meaning of the ECBs inflation target: Keeping inflation close to, but below 2%, is not the same as keeping inflation below 2%. In practice, during the first wave of the financial crisis, the ECB did respond to low rates of inflation of less than 1% by cutting interest rates. Secondly, as Table 1 illustrates, in practice the ECB operates with an inflationary, rather than a deflationary, bias.
Source: http://sdw.ecb.europa.eu/quickview.do?SERIES_KEY=122.ICP.M.U2.N.000000.4.INX
The Bank of Englands Inflation Forecasting Record has been very poor!
Every quarter the Bank of England produces an inflation report, which includes an inflation forecast for the next two years. The inflation forecast is presented as a fan chart. The fan chart approach acknowledges that it is impossible to predict the future rate of inflation with utter certainty. The predicted outcomes shown in darker blue are more likely to occur than the predicted outcomes shown in the lighter shades. An example of a fan chart, taken from the May 2010 Inflation Report, is shown below. At that time inflation was above its target rate. However, the Bank of England justified its decision to keep interest rates low on the grounds that its fan chart predicted inflation to fall below its target rate within the next two years.
Topic 4
36
Figure 3 shows that in May 2010 the Bank of England believed that the most likely outcome is that rate of inflation would fall sharply, but remain above its central target rate of 2% for the remainder of 2010. The Bank also predicted that the most likely outcome is in 2011 the rate of inflation will be below 2%. The fan chart also indicates that the Bank of England believed that there was an outside risk that there could be some modest deflation during 2011 and 2012. However, on the up-side there was also a perceived risk that inflation could rise above 3% during the same period. In the last decade the Bank of Englands inflation forecasting record has been as inaccurate as the Met Offices long-range weather forecasts! However, unlike the Met Office, arguably the Bank of Englands forecasting errors have been asymmetric. The Bank of Englands fan charts have consistently overstated the risk of deflation, whilst consistently underestimating the risks of above target inflation. So why has the Bank of England been so bad at forecasting inflation? There are only two possibilities: The first is incompetence: the Bank of Englands inflation forecasting models could be wrong. The second reason could be that the Bank of England has made forecasting errors on purpose. In the past the Bank of England, by deliberately underestimating the future risk of inflation, has been able to keep interest rates lower than they otherwise would have been. Keeping interest rates artificially low provided a much needed to boost to UK households and firms that had borrowed heavily during the boom period. It could be argued that, when setting interest rates, the Bank of England has demonstrated an inflationary bias. If this situation persists the international community will start to doubt the inflation fighting credentials of the Bank of England. Just how committed is the Bank of England to its inflation target? In practice does the Bank of England make its interest rate decisions on the basis of its inflation forecasts, or does the Bank simply construct its inflation fan chats to justify interest rate decisions that it has already made?
Crisis Economics: The Cutting Edge Topic 4 37
The solid red line in Figure 4 shows the actual rate of inflation in the UK. The dotted lines show the inflation forecasts made by the Bank of England at specific points in the past. The chart shows that the Bank of Englands inflation forecasts have consistently underestimated inflation. For example, the inflation forecast made in 2007 predicted that by mid-2008 UK inflation would be just below 2%. This forecast proved to be laughably wrong. In the middle of 2008 inflation was well over 4%.
2. Economic stability
Economic stability occurs when the economys level of activity stays fairly constant over time. To achieve economic stability, policy makers intervene to moderate both the up and the down swings in the economic cycle. According to Keynesians, inflation targeting increases the chance that central banks will make the interest rate decisions needed to create economic stability.
Topic 4
38
For example, if central banks are asked to set monetary policy to achieve an inflation target, the economy should never overheat. Keynesians believe that economic booms are caused by rising levels of aggregate demand. When the economy starts to run out of spare capacity demand-pull inflation picks up. In the past central bankers allowed the boom phase of the economic cycle to get out of control, creating instability. Today, this instability is less likely to occur. Inflation targets force central banks into raising rates well before booms get out of control. At the same time, the inflation targeting approach also reduces the risk of economic instability created by deep and prolonged recessions. Symmetrical inflation targets force central banks into cutting interest rates at a very early stage in the downswing phase of the economic cycle as soon as inflation falls below its target rate. Keynesians believe that an early slackening of monetary policy will reduce the length and the severity of any recession, contributing to greater economic stability. Economic stability makes it easier for firms to predict the future with greater certainty. As a result business confidence tends to improve during periods of stability, which stimulates investment, leading to higher rates of economic growth.
4. Flexibility
Inflation targets help central banks to achieve the very important goal of price stability. However, in addition, symmetrical inflation targets also enable central banks to make cuts in interest rates in response to the risk of a deflationary recession. Therefore, it could be argued that a symmetrical inflation offers policy makers a degree of flexibility when determining monetary policy.
Crisis Economics: The Cutting Edge Topic 4 39
It could be argued that inflation targeting created three adverse unintended consequences for the UK economy: 1. A destructive speculative bubble in the housing market: cheap and plentiful credit drove up the effective demand for housing, increasing its price (See Topic 5
for further discussion).
2. Rising household debt: house price inflation forced first time buyers into taking on ever higher levels of mortgage debt. Rising household debt reduces long-term living standards because higher interest payments created by larger debts will reduce future disposable incomes (See Topic 5). 3. A huge current account deficit: house price inflation created a positive wealth effect for homeowners. At the time UK banks allowed homeowners to take out second mortgages on their properties. The equity withdrawn was used to purchase (mostly) imported manufactured goods. Rising UK import expenditure pushed the UKs current account balance further into deficit. Borrowing to consume imported goods from abroad created a second layer of UK household debt. At the height of the housing boom in 2007 mortgage equity withdrawal contributed over 12bn to UK aggregate demand. There is evidence to suggest that the Bank of England spotted many of the problems outlined above. For example, in 2004 the Governor of the Bank of England, Mervyn King, warned that UK house prices were, well above what most people would regard as sustainable in the longer term1. Unfortunately, the Bank of England was powerless to act. The Bank could not raise interest rates to prevent this bubble from inflation because at that time CPI inflation was still within its target range and expected to remain there (See Topic 10 for futher discussion).
1.
2. 3. The level of unemployment: If central banks anticipate rising unemployment they could respond by boosting aggregate demand by slackening monetary policy. Keynesian economists argue that slack monetary policy should be used in conjunction with expansionary fiscal policy in order to fight off the threat of recession and rising unemployment. 4. Asset prices: Inflation occurs when the purchasing power of money falls. At present the governments preferred measure of inflation completely ignores the effects that inflation has on the affordability of assets such as housing. If interest rates are to be set according to an inflation target, the target cannot be consumer price inflation. Instead, the new inflation target must be based on a broader measure of inflation that includes asset price inflation. The RPI includes house prices within its average basket of goods. However, it might be argued that the RPI is still too narrow as an inflation measure because there are other assets apart from housing. For example, a new broader measure of inflation that could be used for inflation targeting purposes would have to include the price of other assets, such as shares, land and possibly bonds.
Topic 4
42
Monetary policy concerns adjusting the rate of interest and the money supply in order to affect the real economy and the rate of inflation. In recent times most central banks, the Bank of England included, have set interest rates in order to achieve an inflation target. Inflation targeting is designed to create macroeconomic stability. Central bankers will be forced into raising interest rates during a boom if inflation looks like it could exceed its target. The rise in interest rates will help to cool the economy, ensuring that booms are never left to get out of control. Setting inflation targets will also help to manage down inflationary expectations within the economy. This is important because inflationary expectations affect wage negotiations, which in turn affect both demand-pull and cost-push inflation. The Bank of Englands inflation target is symmetrical, i.e. to keep CPI inflation to within 1% of a 2% central target. Supporters of this type of inflation target argue that deflation and inflation are equally problematic. If CPI looks likely to fall below 1% the Bank of England is obliged to act by cutting interest rates in order to prevent the risk of deflation. The European Central Banks inflation target is to keep CPI inflation close to, but below 2%. Some economists argue that this type of asymmetric inflation target represents a deflationary bias in policy making. In practice, central bankers on both sides of the Atlantic set interest rates with an inflationary bias: deflation is extremely rare. Furthermore, low positive rates of inflation achieved by central banks quickly erode the internal purchasing power of money due to compounding effects. Critics of inflation targeting argue that central bankers should take other variables into account when setting interest rates other than the anticipated rate of inflation. During the boom years a combination of immigration and Chinas rapid industrialisation kept inflation artificially low. As a result, in countries like Britain and the USA interest rates stayed too low for too long. These low interest rates created malinvestment, most noticeably in property, where speculative bubbles formed. Cheap money also encouraged households to borrow and spend, contributing to balance of payments problems. It could be argued that central banks should take into account other variables apart from inflation when setting interest rates. These other variables could include: household debt, asset prices, the exchange rate and the current account balance.
Topic 4 Summary
Topic 4 Questions
1. The Bank of England has two goals: to maintain both price and financial stability. Explain the possible conflicts that the Bank might face when trying to achieve these goals simultaneously. 2. Distinguish between an asymmetric and a symmetrical inflation target. 3. Discuss whether the European Central Bank conducts monetary policy with a deflationary bias. 4. Some economists have argued that the inflation targeting approach to monetary policy was instrumental in creating a property bubble and an unstable UK economy crippled by debt. To what extent do you agree with this view?
Topic 4
43
Source: http://www.housepricecrash.co.uk/graphs-average-house-price.php
The housing market attracts more amateur analysis from would-be economists than any other. The nations media has definitely contributed to the UKs property bubble. Channel 4 led the way, commissioning a plethora of property-related T.V. programmes such as: Location, Location, Location; A Place in the Sun, Home or Away; and, Property Ladder. Even the BBC felt compelled to join in the property-ramping action, running shows such as Homes under the Hammer, and To Buy or Not to Buy. These television programmes have been extremely influential in shaping British attitudes towards property. The main message being that the road to riches was to borrow heavily from the bank in order to buy property. Then, after applying a couple of coats of magnolia, sit back and watch the price of the asset rise, before selling on for a profit at a later date!
Crisis Economics: The Cutting Edge Topic 5 44
Television news bulletins have also been afflicted by property propaganda. Those with vested interests, including: estate agents, mortgage providers and professional organisations, like the Royal Society of Chartered Surveyors, are usually chosen to appear on news programmes to offer their expert view on the likely direction of UK house prices. Arguably these experts tend to be habitual optimists, forecasting rising house prices for the foreseeable future. They rightly point out that house prices are a function of the relative strength of the supply and demand for housing, and that house prices in Britain have risen because the demand for housing has grown at a faster rate than its supply. The consensus view amongst the general public is that the main factor that has driven UK housing demand is immigration: if more people come to live and work in Britain, the demand for housing must go up! This consensus view is incorrect. Housing demand has increased, but most of this increase is not immigration related; the basic flaw being an inability to distinguish between potential and effective demand. Potential demand is an idle want; a desire that is not backed up by an ability to pay. Potential demand does not affect market price. Only effective demand has the power to influence market price. Effective demand is demand that is backed up by hard cash. The vast majority of immigrants that arrive in Britain come with very little cash. They also tend to do low paid jobs. As a result, their ability to influence house prices is extremely limited. The demand for housing amongst immigrants tends to be potential, not effective. This explains why most immigrants in the UK end up living in rented housing. Figure 2: The UK housing market
The supply of housing in the UK tends to be price inelastic. Builders would like to respond to rising house prices by building more houses. However, their ability to do so is limited by the UKs restrictive planning laws. As a result, even small changes in demand create an exaggerated effect on market price. Figure 2 illustrates that during the recent housing boom the demand for housing increased, say from D1 to D2, which forced the price of housing up from P1 to P2. Vested interests, such as mortgage lenders and estate agents, argue that the main factor that drove demand up was immigration. This is incorrect because the demand for housing, like any other good or service is determined by effective, not potential, demand. The real reason for the increase in demand relates to changes in the price and the availability of credit.
Crisis Economics: The Cutting Edge Topic 5 45
1. The increased availability of credit which arose from high lending multiples, high loan-to-value ratios, interest only mortgages, selfcertification of mortgages and loans for buy-to-let property purchase
Most houses are bought with borrowed money. Therefore, the most important factor that affects the demand for housing is the availability of credit. If credit becomes easier to obtain, the demand for housing will increase. During the boom years the demand for housing increased because banks gradually, over time, increased the amount that they were prepared to lend to prospective house buyers. Twenty years ago banks were quite prudent in their mortgage lending. Typically, single buyers were allowed to borrow up to three times their salary, whilst married couples could only borrow 2.5 times their joint income. In addition, buyers were also expected to contribute a deposit. Figure 3: BBA Mortgage Value - Average value of loan for house purchase
Figure 3 shows that the average value of a mortgage granted for a house purchase increased by over 150% during the period from 1997 to 2007. This increase in the availability of credit provided prospective buyers with the hard cash needed to pay higher house prices. Unsurprisingly, over the same period, the average price of a house in the UK rose from 68,504 to 196,478, an increase of 186%. Without the extra credit supplied by Britains banks, house price inflation on the magnitude seen would have been impossible. Credit enabled households to pay higher prices.
Crisis Economics: The Cutting Edge Topic 5 46
To maintain house price inflation during the boom, banks had to feed ever higher levels of credit into the housing market. Examples, of reckless UK sub-prime mortgage lending included: High lending multiples: in the late 1990s banks relaxed the old rule that a borrowers mortgage should not be more than three times higher than their annual salary. Over time lending multiples increased. At the height of the property boom it was possible to find lenders willing to provide mortgages seven or eight times higher than the borrowers income! Lending at high multiples of salary is risky because it increases the size of the borrowers debt relative to their ability to service the debt. At the time the banks defended their lending decisions by making reference to low interest rates. At lower interest rates households could load up on more debt and still be able to make the repayments. Figure 4: First time buyer house price to earnings ratio
During the boom years from 1997 to 2007 UK house prices soared. An important cause of this inflation was rising lending multiples. Figure 4 shows that in 1997 UK banks were on average only willing to lend first time buyers 2.5 times their salary. At the height of the boom in 2007 this multiple had risen to 5.5 times income. The relaxation of bank lending increased the amount buyers were willing and able to pay, increasing the effective demand for housing. High Loan-to-Value (LTV) ratios: before the property boom, lenders required potential home buyers to contribute a deposit towards their purchase. For example, thirty years ago a couple that might have wanted to buy a house for 25,000 might have been asked by the bank to contribute a deposit of 10%, i.e. 2,500. In this case the LTV ratio would have been 90%. The requirement for the borrower to contribute a deposit was justified on the grounds of prudence. From the lenders point of view asking a potential borrower to save a deposit indicated that the borrower was a reasonable risk. Lending to those who lacked the self-discipline to save up a deposit was asking for trouble. In addition deposits would also provide a cushion for the lender just in the case house prices fell.
Topic 5 47
During the boom years UK mortgage lenders gradually relaxed their requirement for prospective buyers to contribute a deposit. As a result UK LTVs rose. Most lenders provided 100% LTV mortgages for first time buyers. Northern Rock went one step further offering potential buyers 125% mortgages. For example, a first time buyer that wanted to buy a house for 200,000 was allowed to borrow 250,000! High LTV lending by banks added extra spending power into the market, forcing up prices even higher. Unfortunately, granting mortgages with a LTV ratio of above 100% creates negative equity. Negative equity is a situation where the mortgage debt exceeds the market value of the house. Negative equity creates a problem for the lender: if the house has to be re-possessed, because the borrower loses their job, the bank stands to make a loss, because the cash generated from the sale of the repossessed house will not be enough to pay off the outstanding mortgage debt. Interest only mortgages: this type of mortgage reduces the monthly cost of borrowing because the borrower has opted to just pay the interest due on their debt. Alarmingly, in 2010, of the 11.4m mortgages in Britain currently outstanding, 41% are interest only! Most of these borrowers are not even aware that their monthly payments are not paying off their mortgages. In effect these homeowners have chosen to rent their homes from their mortgage lender. Interest only mortgages forced the demand for housing up because it enabled prospective buyers to borrow more in order to pay high house prices. Self-certificate mortgages (liar loans): a self-certificate mortgage enables a prospective house buyer to borrow without having to provide documentary proof of their income to their lender. In the past, when banks were prudent, lenders insisted that borrowers had to provide wage slips and bank statements in order to prove to the bank that they were capable of repaying their debt. During the boom years banks gradually relaxed this requirement. In some cases banks actually encouraged borrowers to lie and overstate their income. By doing so the borrower could obtain the additional debt needed to pay higher house prices. Halifax Bank of Scotland (HBOS) was the UKs champion of this form of sub-prime lending. According to former HBOS manager, Michael Bolton, HBOS had five brands, all offering products without proof of income. It was offering a lot of self-cert, a lot of buy-to-let that needed no proof of income and a lot of Halifaxs mortgages were non-verified income loans, which was essentially fast track. Before the credit crunch, as much as 80% of HBOS loans were going through without full proof of income. 1 Unsurprisingly, many of these borrowers subsequently defaulted on their lie-to-buy loans because their debts were too big relative to their actual incomes. The defaults led to huge losses for HBOS, which had to be rescued via a combination of a secret 25.4bn loan supplied by the Bank of England and by the subsequent takeover of HBOS by Lloyds-TSB. In 2004 the BBC carried out undercover research into the UK mortgage market. The Money Programme discovered that banks were creating house price inflation by inviting their own customers to defraud them! The film Mortgage Madness caught bank employees and mortgage brokers advising their clients to lie about how much they earned in order to purchase property that they really could not afford. Prospective buyers were informed that in order to get the cash they needed to purchase their dream home it would be necessary to go down the self-certificate route.
1 http://www.glitec.co.uk/2009/07/no-income-check-with-80-percent-of-hbos-loans/ Crisis Economics: The Cutting Edge Topic 5 48
For example, a prospective buyer seeking a mortgage from a lender willing to lend at 6 times salary needing a mortgage of 600 000 would be advised to self-certify their income as 100,000 per year, even though their real income was well below this level. Self-certificate mortgages were initially targeted at the self-employed who found it hard to provide payslips to prove their income. Today, many industry insiders recognise the misuse of self-certification, using the phrase lie-to-buy to describe this type of mortgage. Buy-to-Let: buy-to-let mortgages are taken out by people that want to borrow to buy a home that they do not wish to live in. Buy-to-Let mortgages are used by property investors who hope to profit from the rental income that they receive and from the hope that rising house prices in the future will provide a capital gain. House prices in the UK are very high relative to rents. Therefore, the yields achieved by property investors are not attractive. Despite this Buy-to-Let is still popular. The main reason being that banks are willing to advance huge loans to those that are willing to speculate on continued house price inflation. From the speculators perspective this proposition is attractive. In the past many of these speculators were able to make their bets without using any of their own money at all. During the boom years of reckless lending banks were willing to advance 100% LTV loans to potential Buy-to-Let investors. Lenders that did require a deposit were helped by builders that specialised in constructing inner city flats. These companies helped their clients by providing cash-back deals. The cash being used to pay any deposit required by the Buy-to-Let mortgage lender. The great depression of the 1930s was caused by ordinary Americans being able to borrow huge sums in order to speculate on rising US share prices. During the roaring 20s the US stock market boomed due to the extra demand for shares created by the wall of borrowed money hitting the market, made possible by reckless bank lending. When the stock market bubble burst, asset prices fell like a stone, however, the debt built up by ordinary Americans remained, and a deflationary depression ensued. The US government reacted by regulating the banks, preventing banks from granting loans to people that wanted to borrow in order to speculate on share prices. Unfortunately, the broader lesson appears not to have been learned. How can it be right for banks to advance huge sums of money to investors that wish to speculate on rising share prices? There is nothing wrong with property speculation, provided that the speculator uses his or her own money, rather than the banks money. Buy-to-Let mortgages financed over 1.1m property purchases in the UK. The impact that this type of lending had on the UK property market should not be underestimated because it created a new type of demand for housing, which was largely speculative.
Topic 5
49
Figure 5 shows the trend in UK real interest rates over the last 25 years. The real interest rate is calculated by subtracting the rate of inflation from the nominal rate of interest. For example, if a bank is prepared to offer its savers a nominal rate of interest of 1.5% at a time when inflation is 5.3%, the real rate of interest on offer for savers will be equal to -3.8%. The decision by the Bank of England to slash nominal interest rates to 0.5% created negative real rates of interest. Negative real rates of interest were designed to boost asset prices and to help the economy move out of recession. To an extent the policy has worked. Poor rates of returns on cash drove money back into property and shares, boosting the prices of these assets. Negative real interest rates also discouraged saving and encouraged a final round of debt driven consumption, which helped the economy out of recession. Figure 5: Real Interest Rates, UK
Source: www.greenenergyinvestors.com/
It could be argued that the inflation targeting approach towards monetary policy also contributed to asset price bubbles. Central banks kept interest rates too low for too long because CPI inflation remained within its target range. During the boom years inflation in the UK remained low due to two factors that were beyond the control of the central banks. The first factor that created low CPI inflation was immigration into Britain from Eastern Europe. The resulting increase in the supply of labour in the UK helped to reduce UK wage inflation. Low rates of wage inflation restrained both demand-pull and cost-push inflationary pressure in Britain. The second factor is the China effect. Rapid industrialisation in China and in the other BRIC countries created a surge in the supply of consumer goods. This increase in world supply helped to keep the lid on prices. Chinas ability to fill the world with low cost products played a crucial role in keeping UK CPI inflation within its target range because many of the products that were included within the UKs CPI basket were made abroad in places like China, rather than in Britain.
3. Speculative demand
The desire to buy housing as an investment has also contributed to UK house price inflation. The belief that house prices always go up has become ingrained in the nations collective psyche. The expectation of future price rises created a self-fulfilling prophecy. Property speculators bought housing in anticipation of a capital gain. The extra demand brought to the market by these speculators created the house price inflation that was anticipated. Ever higher levels of speculative demand were made possible by the relaxation of bank lending. The result was the formation of a speculative bubble in the housing market.
Crisis Economics: The Cutting Edge Topic 5 50
4. Government intervention
The tax system has helped to boost the demand for housing. Capital gains tax is paid when an asset is sold for more than it was bought for. The rate of capital gains tax affects the speculative element of the demand for housing. Gordon Browns decision to reduce the rate of capital gains tax to 18% benefited property speculators because it meant that they kept a greater proportion of their profits. In addition, the income tax system also benefitted Buy-to-Let property speculators. Property investors are obliged to pay income tax on their rents. However, in the UK, mortgage interest is classified as a tax deductable expense. For example, a landlord that bought a house that rents for 2,000 per month, who pays mortgage interest of 1,500 per month, will only pay income tax on the net monthly income of 500. The UK benefits system has also stimulated the demand for Buy-to-Let property. A good example is housing benefit, which is paid by the government to low income households, who would otherwise struggle to pay the rents charged by private landlords. During the Labour government, expenditure on housing benefit soared. Landlords benefited from the extra demand created by housing benefit payments by raising rents. Higher rents increased the yield on property. As a result the demand for housing from investors increased, which contributed to house price inflation. In June 2010 the new government decided to place a cap of 400 per week on housing benefit payments. This change will reduce the effective demand for rented housing. In the future rents are likely to fall, leading to lower yields.
Topic 5
51
1983 30 898 1984 33 117 1985 36 145 1986 40 126 1987 46 315 1988 57 087 1989 68 946 1990 68 950 1991 68 130 1992 64 309 1993 62 455 1994 62 750 1995 61 666 1996 64 441 1997 68 504 1998 72 196 1999 77 405 2000 85 005 2001 92 256 2002 108 342 2003 132 589 2004 156 831 2005 165 807 2006 179 601 2007 196 478 2008 181 032 2009 162 085 2010 167 570 (May)
In the late 1980s the UK economy boomed. The demand for housing increased due to the relaxation of bank lending standards. Wage inflation also contributed to house price inflation too. House prices in the early 1990s fell due to a combination of high interest rates and a severe recession which led to thousands of homes being re-possessed. House prices rose rapidly as a result of interest rate cuts that followed the bursting of the dot com bubble and the 9/11 attacks. Prices carried on rising as lending standards were relaxed. The credit crunch reduced the availability of credit, which led to falling house prices during 2008 and 2009. A combination of the banking bailouts and 200bn of quantitative easing provided UK mortgage lenders with the liquidity required to resume mortgage lending. As a result of this intervention the UK government was able to re-start house price inflation.
Source: http://www.nationwide.co.uk/hpi/historical.htm
The impacts of house price inflation on the UK Economy House price inflation has had a variety of effects on society and the UK economy. Some of these effects have been positive. On the other hand rising house prices have created a range of issues that have reduced the UKs standard of living and have led to economic instability. We can identify six issues: Higher levels of aggregate demand, creating short-run economic growth Higher taxation revenue Increase in the balance of trade deficit Raising the level of household debt Increasing the indebtedness of the banks Heightening wealth and income inequality Diverting investment from the productive capacity of the economy We consider these issues in turn.
Crisis Economics: The Cutting Edge Topic 5 52
The role that mortgage equity withdrawal played in supporting UK consumption cannot be under-estimated. Wage inflation in the UK has been held in check during the last decade by globalisation. At the same time, the cost of living has increased at a steady rate. As a result, real wages in the UK have fallen, particularly amongst the low skilled whose jobs are easy to outsource. In the face of falling real wages, UK households opted to maintain their lifestyles by taking on debt. Figure 6 shows that during the boom years mortgage equity withdrawal was regularly contributing billions of pounds to UK aggregate demand. For example, in 2003 nearly 9% of UK household income was borrowed via mortgage equity release. The credit crunch led to a dramatic fall in consumer spending. The chart shows that by 2008 UK households were beginning to reduce their mortgage debt. The boost to consumption created by rising house prices enabled the UK economy to achieve short-run economic growth. This type of growth arises when GDP increases because the economy is now making fuller use of its existing capacity.
Topic 5
53
House price inflation gave households the confidence to take on additional debt which was used to finance consumption. The increase in consumption created an increase in UK aggregate demand. The increase in aggregate demand from AD1 to AD2 shown in Figure 7 lifted the equilibrium level of national income from NY1 to NY2, which created short-run economic growth of the same amount. During the boom years the extra demand made possible by mortgage equity withdrawal and other forms of debt helped to create jobs in retailing, restaurants, health clubs etc that soaked up the additional discretionary consumer spending.
The Buy-to-Let property bubble indirectly fuelled the UKs demand for imported Italian kitchens, Japanese flat screen HD TVs and Swedish furniture. All of these goods were bought by property developers to renovate their investments.
Source: ONS
Total UK personal debt currently stands at 1,460bn. This is a monumentally large figure, which is well in excess of the entire countrys annual GDP. During the boom years UK aggregate demand was bolstered by the willingness of UK households to take on new lines of credit. In practice aggregate demand cannot be permanently supported by UK households borrowing in order to undertake spending because, eventually, the stock of debt owed grows too large for the debtor to service from their current income. There is strong evidence to suggest that this turning point has already been reached. Record numbers of UK households are defaulting on their debts because they cannot pay them, even at very low rates of interest. The problem with debt is that it has to be paid back, and with interest added on top. Unfortunately, the level of private sector consumption is likely to be crushed in the future. Banks that have been badly burned by their own reckless lending are likely to withdraw credit from households that would like to live beyond their means. Attitudes towards debt are likely to change too. If households begin to re-pay their debts, households will have chosen to spend a lower proportion of their incomes. High levels of UK household debt will make it harder for the UK economy to recover. High levels of personal debt are a reflection of high UK property prices.
Crisis Economics: The Cutting Edge Topic 5 55
5. Insolvent banks
Banks make profit by charging borrowers higher rates of interest than they pay to savers. In the short-run an increase in household debt enabled banks to generate more interest income and, therefore, profit. The bigger the amount owed, the greater the interest income received by the bank, provided that the borrower does not default. The banking crisis started in 2007 when the numbers of households defaulting on their mortgages and credit card debts increased. When a customer fails to repay a debt, the amount owed has to written off against profit. Figure 9: Individual Insolvency in England & Wales, 1987-2009
Figure 9 shows the number of people being forced into bankruptcy. Individual Voluntary Agreements and Debt Relief Orders grew from 2001 onwards. The surge in the number of bad debts resulted in huge losses for the banks that threatened their very survival. To save Britains commercial banks Gordon Brown spent billions of pounds of taxpayers money injecting new capital into the banks via share purchases. In addition, the policy of quantitative easing also improved the liquidity of the UKs banks. By the middle of 2009, the extra lending made possible by these polices re-started UK house price inflation. House price inflation benefits mortgage lenders because it reduces the possibility that a re-possessed house will fail to generate the revenue needed to cover the outstanding debt. Despite the governments best efforts, banks are still suffering from bad losses caused by loans defaulting. According to figures produced by Credit Action in July 2010, UK banks are, on average, writing off over 23m every day in bad loans. Taxpayers in the UK may need to save the UK banking system for a second time because the banks, spurred on by government, are still making loans to people who may not be in a position to pay them back.
House price inflation created a divided nation of property haves and property have nots. According to Martin Weale, chief economist at the National Institute of Economic and Social Research, house price inflation has compromised inter-generational equity: If land prices increase to a permanently higher level, then the cohort which happens to own the land at the time enjoys a windfall which it can realise by selling its land to younger cohorts, reducing the need to accumulate other forms of capital to fund retirement, 2
7. Malinvestment
Malinvestment is a term used by Austrian economists to describe wasteful investment that does not add to the productive capacity of the economy. The UKs property bubble is a classic example of malinvestment. During the boom years UK banks focused their lending on the property sector. Bank loans made to property speculators have not increased the productive capacity of the economy. Instead of making loans to property speculators, UK banks should have been making loans to UK manufacturing firms that wanted to borrow in order to expand or to modernise. If the UK is to achieve a sustainable recovery the economy must be re-balanced in favour of production. Bank lending should support production, not wasteful speculation.
Conclusions
Booming property prices created a positive wealth effect which encouraged households to borrow in order to finance consumption. The increase in aggregate demand that followed helped the UK economy to achieve short-run economic growth. The economic costs of this period of an unsustainable form of economic growth have now been acknowledged. Rampant house price inflation led to soaring levels of household debt, which almost brought down the entire financial system. However, the social effects of the housing bubble have yet to be fully acknowledged by the British media. Take family life, forty years ago it was possible for those earning an average income to buy a respectable house on one income without having to take on too much debt. In the 1980s and 1990s the number of dual income households rose. The growth in the number of dual income households led to higher house prices because house buyers with two incomes can afford to pay higher monthly mortgage payments than single income households. Today, in the majority of households both parents work. However, in many cases, virtually all of the income earned by one of the parents goes towards servicing the super-sized mortgage debts created by house price inflation. The move towards dual income households has definitely helped the banks; bigger mortgages have boosted incomes of Britains banks. Unfortunately, the main casualty created by this trend has been family life. British workers endure the longest working hours in Europe. Long working hours reduce utility because less time is available for leisure. Long working hours have not even increased the material standard of living for most UK households because a very high proportion of the extra income generated from dual incomes and longer working hours flows straight to the banks via interest payments charged on mortgage debt! In 2007 the Childrens charity UNICEF reported that British children were the least happy in the developed world3. According to the survey many British children felt neglected by their parents. Might some of this neglect stem from the UKs long working hours? And what created this long hours culture? Could it have been created, in part, by house price inflation? House price inflation has turned Britain into a nation of debt slaves.
2 http://www.niesr.ac.uk/pubs/searchdetail.php?PublicationID=2654 3 http://news.bbc.co.uk/1/hi/6359363.stm Crisis Economics: The Cutting Edge Topic 5 57
The housing market is cyclical. In practice house prices do not always go up! House price booms tend to be followed by house price crashes. House prices are determined by the relative strength of the supply and demand for housing. The most important factor that affects the price of housing is the price and the availability of credit because this is the most important factor that affects housing demand. House prices will only increase if lenders and borrowers are willing to accept mortgages that are higher than the mortgages granted to the previous buyer. House price inflation encouraged the UK to live beyond their means. Many homeowners used their houses as cash machines by taking out second mortgages, which were then spent on goods and services, creating short-run economic growth.
1. Potential demand is an idle want, unlike effective demand, which is backed up by an ability to pay. Explain why immigration from relatively poor Eastern European countries, such as Poland, might add little to the effective demand for UK housing. 2. The most important factor that affects UK house prices is the availability of credit. To what extent do you agree with this statement? 3. Should the UK government intervene more actively to regulate the UK mortgage market? 4. Over the last 15 years UK house prices have soared. Has house price inflation added to, or compromised, the quality of life in the UK?
Topic 5
58
This has forced governments into tax increases and public spending cuts. If electorates refuse fiscal consolidation governments might be forced into more quantitative easing. Gold offers excellent insurance against the risk of inflation because unlike fiat currency it cannot be printed. In recent years the price of gold has soared. Many investors clearly expect politicians to deal with the challenges posed by high levels of debt by choosing quantitative easing over fiscal austerity. They expect governments to pursue policies designed to inflate debt away.
2. The UK from March 2009 until February 2010: QE to indirectly monetise a fiscal deficit
In some countries liquidity (cash) injected into the economy via quantitative easing has been used by central banks to purchase second-hand government bonds from private institutions, such as banks and insurance companies. In the UK in 2009 the Bank of England created 200bn. In theory the cash could have been spent on buying up corporate bonds, such as newly-issued mortgage backed securities. In practice well over 90% of the new cash created was spent on government bonds. However, unlike the example of Zimbabwe, the Bank of England insisted that they would not use QE cash to buy newly-issued government bonds. The Bank of England would not help the UK government to directly monetise its fiscal deficit. Instead, the 200bn could only be spent on purchasing second-hand government bonds held by private institutions. This type of quantitative easing undertaken in the UK increased the liquidity of commercial banks, insurance companies and pension funds that might have bought government bonds in the past. Quantitative easing enabled these financial institutions to swap any government bonds that they might have on their balance sheets for newly created cash. The financial institutions now had the cash needed to finance new loans to households and firms. At the time, the UK economy was suffering from a credit crunch induced recession. Keynesians argued that the economy required new lines of credit to get the economy moving again. However, it could be argued that the UKs policy of quantitative easing indirectly monetised the UK governments fiscal deficit because the policy made it easier for the government to sell its new debt. In 2009 the government had to find buyers for over 150bn of debt. The 200bn of liquidity injected by the central bank certainly helped the Treasury; during that year the Bank of England was the only net buyer of UK government bonds! As a result of the UKs QE programme the Bank of England is now the proud owner of UK government bonds that total more than 30% of the UKs national debt. Figure 1 shows how the Bank of England spent the cash created by the quantitative easing programme. When the policy was announced it was expected that the Bank of England would spend most of the new cash created on corporate bonds. Figure 1 shows that this was not the case. Month after month the Bank of England bought more and more government bonds, adding weight to the argument that the Bank of England was indirectly monetising the governments fiscal deficit. This is why the amount spent on corporate bonds and commercial paper is barely visible in Figure 1. The last of the 200bn of cash created was not spent until spring 2010, explaining why the bars on the chart that only run until September 2009 do not reach 200bn.
Topic 6
60
Governments finance fiscal deficits by selling government bonds. In the UK these bonds are referred to as gilts. The deterioration of the governments finances has meant that the government has had to sell more of its gilts. Fortunately, the policy of quantitative easing made this easier. In a very short period of time the Bank of England has become a very important buyer and holder of UK government debt. Supporters of quantitative easing argue that quantitative easing has helped to keep interest rates low. If the government had to find genuine buyers for its gilts, higher rates of return would be required.
3. The US from 2008 onwards: QE used to buy corporate bonds and US government debt
In the USA the American government also used cash created by quantitative easing to buy US government bonds held by American banks. However, unlike the Bank of England, the American central bank, the Federal Reserve, spent a gigantic sum of money buying up bonds issued by American companies.
Crisis Economics: The Cutting Edge Topic 6 61
For example, the Federal Reserve spent $1.25 trillion buying up American mortgage backed securities. The Federal Reserve also used QE cash to buy other types of securitised private sector debt, including car and student loans!
Why quantitative easing might be necessary: liquidity traps and all that
According to Keynesians, recessions are caused by a lack of aggregate demand in the economy. To counter recession, Keynesians favour demand-side policies, such as expansionary fiscal policy and slack monetary policy. Unfortunately, in the depths of a recession, conventional monetary loosening may prove to be ineffective in terms of boosting aggregate demand and employment. There are two reasons why monetary policy can lose its traction:1. In a severe recession the economy might find itself stuck in a liquidity trap. A liquidity trap is a situation where interest rate cuts fail to stimulate aggregate demand in the conventional way. When the economy is stuck in a liquidity trap the monetary transmission mechanism breaks down. For example, usually interest rate cuts will increase private sector consumption. Unfortunately, if consumer confidence has been shattered by a long-lasting and deep recession consumers may decide to save any increase in their disposable income created by a fall in interest rates that reduces their monthly mortgage repayments. Furthermore, cuts in interest rates might make credit cheaper. However, the increase in debt-fuelled consumption expected might not occur if households have reassessed their attitude towards personal debt and are now in the process of deleveraging. The same principle also applies to private sector investment; cuts in interest rates might not cause the increase in investment normally expected. Firms will not borrow to invest, even if borrowed money is cheap, if entrepreneurs are pessimistic about the future. Investing to add capacity will not take place if entrepreneurs believe that sales in the future are likely to remain flat, at best. If the economy is in a liquidity trap, cuts in interest rates will not help to boost the level of aggregate demand. Economists liken this situation as trying to push on a string. 2. The central bank might no longer be able to cut interest rates because nominal interest rates might already be close to zero. For example, the Bank of England and the Federal Reserve started the recession with rates of interest that were already low by historical standards (approximately 5%). Furthermore, both central banks cut interest rates sharply thereafter. The Bank of England shot off all its monetary policy bullets in its arsenal very quickly. Once interest rates approached zero there was nothing further that the central banks could do. In practice interest rates cannot be reduced to below 0%, because if commercial banks start charging interest on savers deposits cash will be quickly withdrawn from the banking system and hoarded at home.
Topic 6
62
Suppose that the UK government issues a bond with a face value of 10,000 which might offer investors an annual coupon payment of 1,000. At the time the bond was issued the bond offered the investor that bought it a 10% return. Bonds are bought and sold in bond markets. The price of a bond can vary significantly according to the relative strength of demand and supply for that type of bond. The central banks decision to use quantitative easing to buy up UK government bonds might mean that the bond that offers a 1,000 coupon might now sell for 11,000. If this happens the bond now only offers investors a return of 1,000 / 11,000 * 100 = 9.1% Quantitative easing was designed to reduce commercial interest rates by lowering the yields on offer for holding government bonds. To compete, commercial banks will have to cut their interest rates too, leading to lower commercial rates of interest. Lower commercial rates of interest would help the economy to recover. Some economists estimate the quantitative easing reduced commercial rates of interest in the UK by approximately 1%.
If the savings ratio can be decreased, the level of consumption within the economy will rise, even if incomes remain flat. In practice it is very difficult to reduce nominal rates of interest to below zero because households will respond to bank charges by withdrawing their cash from savings accounts in order to keep it at home instead, to avoid the charge. However, inflation allows the central banker to create a negative real rate of interest. For example a savings account that pays 1% interest will offer the saver a negative real rate of return of -2% if the rate of inflation is 3%. Deflation is to be avoided at all costs because even a nominal interest rate of 0% will create a positive real rate of interest for savers. Quantitative easing reduced both nominal and real rates of interest, providing UK savers with a powerful incentive to spend rather than to save. Furthermore, many people in Britain also believed that quantitative easing would eventually lead to higher rates of UK inflation and a weaker currency (these people have been proved to be correct). The expectation of higher rates of inflation and a weaker currency encouraged savers to withdraw their sterling savings in order to spend them before they lost value. If policy makers can create a convincing threat of inflation savers will respond by withdrawing their savings and spending them, which will stimulate aggregate demand, pushing the economy towards recovery.
Evaluation
The effectiveness of quantitative easing was limited by the behaviour of UK banks. In practice commercial banks hoarded the QE cash they received from the government. For Keynesians the reluctance of the commercial banks to extend credit made the UKs recession longer. Quantitative easing created a moral hazard. The British and US economies fell apart in 2008 because policy makers had kept interest rates too low for too long. Low interest rates had created a mountain of debt in both countries. Borrowing to consume can create short-run economic growth. However, this strategy does not create a sustainable form of economic growth. A crisis caused by debt cannot be solved by
Topic 6
65
more debt. Both economies will need to go through a period of deleveraging before a sustainable form of economic growth becomes a possibility. Quantitative easing creates a moral hazard because it sends out the wrong set of incentives. Long-term economic growth is created by investment. To fund high levels of investment, high levels of saving are required. Using quantitative easing to lower real interest rates discourages saving. Banks rely on savers for their loanable funds. If banks cannot attract savers they will not be able to finance many business loans for investment purposes. Britain and the US needs to follow the Chinese approach. In China the savings ratio is 40%, which means that the average household saves 40% of their income. There is no shortage of loanable funds in China. In China investment equals 40% of the countrys GDP. It should come as no surprise to anyone that China has been able to achieve economic growth rates of 10%. Meanwhile in Britain and the US our economies struggle, even in a good year, to achieve growth rates of 3%. The citizens of both countries must be encouraged to save again because without saving there can be no investment, and without investment there can be no economic growth. In Britain and the USA predominately Keynesian policymakers, obsessed with the paradox of thrift, focus solely on achieving short-run economic growth by adopting policies like QE which are designed to boost aggregate demand. Unfortunately, the opportunity cost of these policies is much slower rates of long-term economic growth. QE enables the Treasury to run larger fiscal deficits without the need to raise interest rates. Running fiscal deficits might boost short-run economic growth. However, in the long-term if governments run fiscal deficits year after year the national debt will increase. Servicing this debt will crowd out private sector activity. The Bank of Englands attempt to indirectly monetise the UK governments fiscal deficit by printing cash has increased the UKs narrow money supply. Monetarists believe that quantitative easing can be highly inflationary and destabilising.
Topic 6
66
In 2009 the US and British economies were both in recession operating at an equilibrium level of GDP of NY1 because aggregate demand was low and stable at AD1. Keynesians hoped that quantitative easing, along with zero interest rates and a fiscal stimulus, would increase the level of aggregate demand from AD1 to AD2. Firms would respond to the extra spending by raising output and not by raising price because they have spare capacity. As a result, the policy creates economic growth of NY1 to NY2, without any inflation, the average price level remains at its old level of AP1. Quantitative easing will not create demand-pull inflation until the economy begins to run out of spare capacity. Keynesians would acknowledge that it would be a mistake to use quantitative easing if the economy was starting from an equilibrium such as Y/Fe. The economy is producing its full employment output level because the level of aggregate demand is high and stable at AD3. In this situation it would be a mistake to use quantitative easing or any other policy designed to boost the level of aggregate demand because the result will be inflation. Firms cannot respond to the increase in aggregate demand from AD3 to AD4 by increasing output because they are already producing as much as they are able to. Instead, firms will respond by raising their prices, pushing up the average price level from AP2 to AP3. In 2008 and 2009 Keynesians argued that quantitative easing would not create demandpull inflation. They believed that the economy had huge amounts of spare capacity, which would be able to soak up the extra spending power created by quantitative easing. According to the Keynesian paradigm, demand-pull inflation will not occur whilst the economy has a negative output gap. A negative output gap occurs when the economys output level is below its full employment output level.
Monetarists assume:
That the value of V is constant in the short-run. In other words, in the short-run the speed at which money is circulated around the economy is fairly stable. That T, the total volume of goods and services produced in the economy in a year, will also be fairly stable in the short-run. From one year to the next the value of T will tend to increase in line with the economys rate of economic growth. For example, if the economy grows by 2% this year, the volume of goods produced during the same year will also increase by 2%. In this case the value of T for the year will be 2%.
Monetarism in practice
Monetarists argue that because V is a constant in the short-run, inflation can only come about as a result of a situation where the money supply, M, has grown faster than the rate of growth of the economy, T. For example, if the government or central bank allows the money supply to grow by 4% the value of MV (total expenditure) will also increase by 4% too because monetarists assume that the value of V is constant in the short-run. By definition, if the value of expenditure rises by 4% the value of receipts must also rise by 4% too. At the same time the economy has grown by 1%, therefore, the value of T is 1%. In this situation, according to the equation of exchange, there can only be one outcome. The value of PT must rise by 4%. However, if the T component of PT has only risen by 1%, the average price level must increase by 3%. In summary a 4% growth of the money supply combined with a stable velocity of circulation and an economy that has grown by 1% produces a 3% increase in the average price level. It is important to appreciate that monetarism can also explain deflationary episodes. During the great depression of the 1930s, the US economy suffered from deflation because the money supply contracted faster than national output. The value of P fell because M decreased faster than T.
Topic 6
68
In the 1980s the UK government adopted monetarist policies to reduce inflation. The government reduced the UKs rate of inflation by using monetary policy to control the rate of growth of the money supply to ensure that the money supply never grew faster than the economy. The government set money supply targets as part of what was known as the Medium Term Financial Strategy. If monetarism is to work governments must be able to accurately predict the value of T (economic growth) in the future. Secondly, the government must then be able to control the growth of the money supply so that it never grows faster than the economy. For example, if the government predicts that the economy will grow by 2% next year the government should not allow the money supply to grow any faster than 2% because the result will be inflation, i.e. an increase in the value of P.
According to Fishers equation of exchange, one might have expected a sharp acceleration in American inflation following the Federal Reserves decision in 2009 to increase the narrow money supply by 100%. By mid-2010 the inflation anticipated had not arrived. Does the absence of serious inflation in the USA, following a rapid monetary expansion, undermine the theory of monetarism? Other economists argue that the impact that quantitative easing has had on the monetary base has been partially offset by a period of credit contraction that has slowed the growth of the broad money supply.
Crisis Economics: The Cutting Edge Topic 6 69
Broad measures of the money supply, such as M4, include cash and credit. Figure 5 illustrates that by May 2010, despite UK quantitative easing, the annualised rate of growth of M4, had fallen to 3%. Figure 5: The money supply (M4) in the UK, 2008-2010
Source: www.bankofengland.co.uk/statistics/m4/2010/may/M4SA.GIF
Rising inflation encourages households to withdraw, and spend, any cash savings that they might have before they lose value. Incomes will also be spent faster too. This will lead to an even higher velocity of circulation and, therefore, an even higher rate of inflation. The money printing policies favoured by Mervyn King and Gordon Brown might have saved the UK economy from a conventional deflationary depression. Instead, we might now face a hyperinflationary depression similar to the one suffered by Germany in the 1920s. The full impacts of quantitative easing may take time to show through.
Topic 6
71
Quantitative easing (QE) occurs when central banks create money in order to stimulate the economy. In the UK most of the money created via quantitative easing was used to buy UK government bonds. Many of these bonds were owned by British banks. Swapping bonds for newly-created QE cash improved liquidity, giving UK banks the opportunity to make new loans. Quantitative easing also boosted bond prices, which helped to push down commercial rates of interest. Supporters of QE argued that in addition to Zero Interest Rate Policy (ZIRP) and record fiscal deficits, the British and the US economies needed additional stimulus in order to prevent a 1930s style deflationary collapse. The extra spending power injected into the economy via QE would help the economy to recover from the effects of the credit crunch. Keynesians, who believe in output gap theory, argue that QE will not create inflation in Britain or the USA because in both countries there is plenty of spare capacity available: unemployment remains high. Critics of QE believe that printing money will not affect the real economy. Instead, QE transfers wealth from savers to borrowers via inflation. Monetarists reject the Keynesian theories on the causes of inflation. Recessions have a nasty habit of destroying capacity because once closed down factors of production quickly disperse. In practice it is not quick and easy to re-open factories that belong to firms that have gone into liquidation: production cannot be restarted. Monetarists believe that inflation is always and everywhere a monetary phenomenon. QE expands the money supply. If the money supply grows at a faster rate than the economy the result will be inflation. At the present time inflation only remains relatively low because the velocity of circulation of the money supply is very low. However, this could change quickly. Printing money in Zimbabwe eventually led to hyperinflation despite the fact that at the time the economy was suffering from very high rates of unemployment and, therefore, running a huge negative output gap.
1. Explain how quantitative easing affected the UK governments ability to finance its fiscal deficit 2. Evaluate the arguments put forward to justify the Bank of Englands 200bn quantitative easing experiment. 3. Keynesians argue that central bankers should not be overly concerned about inflation if an economy is experiencing a negative output gap. Evaluate this view. 4. According to monetarists, inflation is always and everywhere a monetary phenomenon. Quantitative easing has led to a sharp increase in the UKs narrow money supply. From a monetarists perspective, explain why this increase in the money supply might not immediately lead to a sharp rise in the UKs rate of inflation.
Topic 6
72
Qualifying criteria: the Stability and Growth Pact and the Maastricht convergence criteria
Not all members of the EU are part of the eurozone. To become eligible for membership of the single currency an applicant country must meet the rules of the Stability and Growth Pact (SGP), namely: 1. Governments must not run an annual fiscal deficit in excess of 3% of GDP 2. The governments total stock of debt, i.e. the national debt, should not exceed 60% of GDP In addition, to qualify for membership the applicant country must also meet the Maastricht convergence criteria for at least two years before euro entry. The applicant country must meet the following conditions: 1. Have low inflation, which is below the eurozone threshold applicant countries must not have an inflation rate that is more than 1.5% higher than the inflation rates of the three countries that have the lowest rates of inflation in the Eurozone. 2. Have relatively low interest rates on government bonds. High interest rates on government bonds are deemed to be undesirable because they indicate a lack of confidence on the part of the bond market. Governments that are perceived to be at greatest risk of defaulting on their debts are punished by the bond market. Governments in this position are forced into paying higher interest rates to compensate for the extra risk of holding these bonds, i.e. a risk premium has to be paid. The EU wants to avoid the risk of a member state defaulting on its debts because it would cause instability for the whole of the eurozone. Therefore, in order to qualify for membership long-term bond yields on government debt must be within two percentage points of the best three Eurozone countries. 3. The applicants currency has to be relatively stable. The applicant country has to agree to join a semi-fixed exchange rate called ERM II (Exchange Rate Mechanism two). To qualify for euro membership the applicant country must keep its exchange rate to within 15% of a central exchange rate. The central exchange rate against the euro is determined by the government and the central bank of the applicant country. 4. Low and stable rates of interest. The interest rate set by an applicant country must not be more than 2% above the interest rate set by the ECB.
Crisis Economics: The Cutting Edge Topic 7 73
At the time Browns five tests were criticised on the grounds that they were deliberately vague. For example, how would one be able to know whether the UK economy was going to be good for jobs or not? Surely, the answer to this question could only be ascertained after the event, i.e. years after a decision to ditch the pound in favour of the euro. It could be argued that Browns five questions were purely rhetorical, i.e. asked just for effect, with no answer expected. Brown, unlike Tony Blair, was opposed to UK entry into the single currency. Browns five tests were deliberately vague. The ambiguity built into the tests gave the chancellor ample room to argue that that the UK could not join the euro just yet because we still had not met all of the tests yet.
Currency fluctuations also affect UK firms that import stock or components from suppliers operating inside the eurozone. If the pound suddenly fell against the euro, the sterling cost of imported stock would rise, even if the price in euros remained constant. To maintain sterling profit margins UK firms would have to raise the prices charged to their British customers. Unfortunately, higher prices are likely to lead to falling sales volumes for the UK firms affected. On the other hand, a rising exchange rate is likely to have the opposite effect. The UK firm buying the imported goods might use the change in the exchange rate as an opportunity to cut their sterling prices, leading to higher sales volumes. Fluctuating exchange rates make it more difficult for firms to accurately predict their sales and profits. When faced with uncertainty, many firms tend to err on the side of caution when making investment decisions. Low levels of UK investment harm international competitiveness and the countrys economic growth prospects. Joining the euro would help to boost UK investment because all the uncertainties created by a fluctuating exchange rate against the euro would now be removed. For example, entrepreneurs exporting to France should have greater confidence in their sales forecasts for this market because there would no longer be an exchange rate to worry about. As a result, UK entrepreneurs should be more inclined to expand and invest, which would help the British economy. If investment can be increased the economy should grow at a faster rate, creating a higher material standard of living for UK citizens. Joining the euro should also give smaller UK firms a greater incentive to exploit the opportunities presented by the European Single Market. At present many small UK firms might be put off from exporting their product into the eurozone due to exchange rate risks. Small firms are more likely to be discouraged by exchange rate risk because they are less likely to be able to afford expensive hedging contracts (insurance against an adverse movement of the exchange rate that results in a loss of profit). If the UK joins the single currency these smaller firms might choose to begin trading with the eurozone more actively. Free trade should be encouraged because it promotes economic efficiency. Trade theory suggests that countries should be encouraged to specialise according to their comparative advantage. By doing so factors of production can be transferred from sectors where productivity is low. The factors of production freed up can then be re-deployed in other industries where productivity is much higher. The increase in productivity created by specialisation will increase GDP, creating material progress.
If the UK joined the euro foreign banks might be more inclined to set up branches in the UK. Incomes and profits generated from the UK would no longer have to be converted back into euros. The UK consumer would certainly benefit from new entrants. The increase in competition by new entrants created would almost certainly lead to lower banking charges and a better all-round deal for customers. The Single European Act of 1992 was designed to sweep away hidden barriers to trade within Europe. Examples of hidden barriers to trade include: excessive bureaucracy and delays at border crossings; public sector procurement policies that are designed to favour domestic producers, rather than the tax payer; manipulating indirect tax rates to divert expenditure from imports to domestically-produced substitutes; product quality standards that block out non-conforming imports; and subsidies paid to domestic producers. By removing these hidden trade barriers the EU hoped to create greater international trade between member states. The move towards greater free trade between member states would increase competition within Europe, which would lead to greater choice and lower prices for consumers. At the time, many economists criticised the EU on the grounds that, to work well, a single European market would require a single European currency to accompany it. A single market without a single currency would be ineffective in terms of promoting greater trade because the uncertainty created by exchange rate fluctuations would matter far more than trying to abolish hidden barriers such as excessive bureaucracy at border crossings. Setting up a single European market without a common currency would fail to produce meaningful results in terms of creating further economic integration within Europe. Exchange rate fluctuations between member states making up the single market would create tremendous uncertainty for firms, which would hold back trade between member states. This can be removed by a single currency. At present the UK is theoretically part of the European Single Market. However, the decision to retain the pound sterling means that we are arguably not receiving the full economic benefits or potential offered by the Single European Market.
Topic 7
76
4. An external discipline
At present the UK government allows the pound to float freely against the euro. In a floating exchange rate regime exchange rates tend to move automatically in the direction required to correct a current account disequilibrium. For example, if the UK economy lost some of its international competitiveness one would expect the demand for UK exports to fall, leading to a fall in the demand for sterling on FOREX markets. At the same time, worsening UK international competitiveness should lead to a rise in import expenditure, and hence an increase in the supply of sterling on FOREX markets. The combination of a fall in the demand for sterling and a rise in its supply will lead to a fall in the exchange rate. A fall in the value of sterling would make UK exports cheaper and UK imports more expensive. As a result one would expect the current account deficit to fall, provided that the Marshall-Lerner condition has been met. It could be argued that a floating exchange rate against our most important export market, the eurozone, has promoted inefficiency in Britain. Many firms in the UK have relied on a falling pound for their international competitiveness. In a floating exchange rate environment firms do not have a strong incentive to take responsibility for their own internal efficiency. Why bother to make the tough decisions needed to keep costs under control when a weakening currency will do it for you? If the UK joined the euro the option of allowing the pound to drift down against the Euro would no longer exist. Once inside the eurozone British firms would have to behave differently. With the bailout option of a currency depreciation now gone, UK firms would have to become more efficient, or face the threat of liquidation. The external discipline provide by eurozone membership would force UK firms into improving their efficiency, which would boost economic growth. The governments decision to keep the pound has created a destructive moral hazard; why bother to make the tough decisions needed to keep costs under control when a weakening currency will do it for you?
Before the euro was introduced the eurozone economy was operating in equilibrium at full employment producing a real income of Y/Fe 1 because the level of aggregate demand was stable at AD. The level of employment at Y/Fe was E1. Following the introduction of the euro productivity rose; this pushed the LRAS to the right, from LRAS1 to LRAS2. If the level of aggregate demand remains constant at AD, the increase in aggregate supply will cause a rise in the level of GDP from Y/Fe1 to NY2. The extra competition and free trade created by a single currency causes the average price level to fall from AP1 to AP2. The increase in productivity also causes the employment line to shift to the right from Employment line 1 to Employment line 2. An output level of NY2 can now be produced with only E2 employees. To prevent a rise in unemployment and deflation of AP1 to AP2, the ECB might consider slackening monetary policy in order to allow aggregate demand to increase from AD to AD1. If aggregate demand can be increased to this level the level of employment within the eurozone will not fall. The extra productivity created by the euro will have been put to good use; the increase in aggregate demand forces national output up from NY2 to Y/Fe2.
However, this policy might prove to be absolutely wrong for the UK economy, which might be enjoying a boom period at the same time. The low interest rate set by the ECB to suit France and Germany might exacerbate inflationary pressure within the UK economy. Member states of the EU have very different economies. Firstly, some countries are far richer than others. Secondly, the economic structure of the economies that make up the EU can be very different. Some member states, such as Germany, have economies with relatively large manufacturing sectors. However, in other countries the economic structure might be completely different. For example, in the UK financial services and retailing are the dominant sectors. In recent years the enlargement of the EU into Eastern Europe has exacerbated these differences. Given these circumstances it could be argued that in the future when countries like Latvia and Poland are allowed to join the euro there will be an even greater strain on a one size fits all monetary policy. An interest rate of 10% might be suitable for a country like Poland. However, Germany might need a much lower interest rate, say 5%. In the circumstances what should the ECB do, should they split the difference and set an interest rate of 7.5%? If so the interest rate would be wrong for both countries. The theory of optimum currency areas is relevant to this discussion. An optimum currency area is a geographical region that has a fairly homogenous economy that would cope with a single currency and a single interest rate. Some economists argue that the eurozone is a good example of an optimum currency area. Since the introduction of the euro the economic cycles of the economies that make up the eurozone have become more synchronized. If the economies of Italy, Germany, Ireland etc are all in a boom at the same time the interest rate set by the ECB will be more likely to meet the individual needs of each eurozone country. On the other hand, other economists argue that the eurozone is too large and diverse to be a good example of an optimum currency area. According to this group, the Eurozone will always be too diverse to cope with a one-size fits all monetary policy. According to the American economist, Robert Mundell the criteria that need to be fulfilled to create an optimum currency area are:
For example, an Italian doctor seeking work in Finland might find it difficult to find work in a Finnish hospital because his or her qualifications are not accepted by the Finnish authorities. The second factor that reduces the geographical mobility of labour in Europe is language. Unemployed Italians would find it very difficult to find work in Finland if the only language they can speak is Italian. The EU single market has a single currency, but not a single language. Even if this issue can be resolved, one further factor remains: will workers be prepared to leave their families and friends in a depressed region in search of work abroad elsewhere within the eurozone? If not regional inequalities will persist in the long-run, which will compromise the effectiveness of a common currency and a common interest rate.
3. Collective responsibility
According to monetarists inflation is always and everywhere a monetary phenomenon. Inflation is caused when the rate of growth of the money supply (M) exceeds the rate of growth of national output (T). Fiscal deficits have to be financed by government borrowing. Typically this involves the government selling bonds to interested investors. Bonds are designed to act as a store of value. However, they are also relatively liquid because bonds can be sold before they mature. Therefore, it could be argued that bonds are a type of near money. Running a fiscal deficit will boost the volume of bonds in circulation, increasing the broad money supply. Over the last decade, eurozone countries such as Portugal, Greece and Italy have run large budget deficits that have exceeded the 3% limit set out in the SGP on a fairly regular basis. On the other hand, at the same time, other eurozone countries, such as Germany and Finland, have complied with the EUs fiscal rules. Monetarists argue that in order to control inflation in the eurozone the ECB must control the rate of growth of the money supply. To control the growth of the eurozone money supply all member states will need to follow the rules of SGP. If the eurozone money supply grows at a faster rate than eurozone output the result will be inflation. The inflation created by fiscal incontinence in Italy or Greece will adversely affect producers and consumers in countries like Germany and France. To combat the inflation created by the reckless Italian and Greek governments the ECB might have to tighten monetary policy for the whole of the eurozone. It could be argued that this situation is very unfair. The Finnish and the German economies end up suffering from high inflation and high interest rates because the Italians and the Greeks refused to follow the rules of SGP! It could be argued that the UK should not join the Euro until all member states can be coerced into following the rules of the SGP.
Topic 7
81
Did the decision to retain sterling help the UK to counter the global financial crisis?
Modern Keynesian economists like Professor Blanchflower have argued that the UKs decision to stay out of the euro helped the economy to recover faster from the global crisis than eurozone economies such as Ireland and Spain2. According to the Keynesians, the UKs decision to keep the pound enabled the government to engineer an export-led recovery by pursuing policies that were designed to lower the value of the pound. The logic of this argument is based on the premise that a weaker currency will enable UK firms to cut their export prices. Lower export prices will (hopefully) lead to increased export income.
2 http://www.newstatesman.com/economy/2010/03/greece-euro-germany-8364-debt Crisis Economics: The Cutting Edge Topic 7 82
At the same time, a weaker currency will also boost import prices, which will (hopefully) lead to falling UK import expenditure. The improvement in the UKs current account balance created by a weaker currency will stimulate the last component of aggregate demand, net expenditure on exports (X-M). Figure 2: The stimulus of a weak currency
The credit crunch led to a rapid fall in the level of UK aggregate demand from AD2 to AD1. As a result, the economy found itself in recession producing an output level of just NY1. The Bank of Englands decision to slash interest rates to 0.5% and to inject 200bn into the economy via quantitative easing made sterling less attractive to buy and hold. The Bank of Englands policies created a 25% fall in the value of sterling. It was hoped that the fall in the exchange rate would improve the international competitiveness of UK firms by pricing them back into their markets both at home and abroad. The increase in net export income created by the fall in the exchange rate should shift the aggregate demand curve to the right, from AD1 to AD2, which will lift national output from NY1 to NY2. Countries such as Ireland and Spain were not able to depreciate their currency against their European neighbours to create an export-led recovery because they had opted to join the euro. Countries such as Ireland that have elected to use the euro now run what amounts to a fixed exchange rate against other eurozone economies. To recover their international competitiveness countries like Ireland will need to go through a painful period of nominal wage deflation. Wage deflation is unpopular with employees for obvious reasons therefore it tends to be resisted. As a result the Irish economy has found it far harder to recover from the credit crunch than the British economy. Membership of the euro meant giving up the automatic stabiliser effects of a floating currency on aggregate demand.
But so far a weak pound has failed to produce the anticipated export-led recovery
Theoretically, a weaker currency should boost aggregate demand, creating an exportled recovery. However, by the summer of 2010 the UK economy had failed to respond in the manner expected. Despite the fall in the exchange rate, UK export income remains disappointing, whilst at the same time, the countrys appetite for imports appears to be undiminished. Trade figures released in July 2010 showed that the UKs trade deficit had been worsening, rather than improving. What has gone wrong? Why has a weaker currency failed to deliver the export-led recovery anticipated by the Keynesians? There are three possible reasons that could be put forward to explain why:
Crisis Economics: The Cutting Edge Topic 7 83
1. The UK economy has not met the Marshall Lerner condition yet
The MarshallLerner condition states that a weaker currency will only improve a countrys current account balance if the sum of the price elasticities of demand for imports and exports exceeds one. A weaker currency will definitely make import prices rise. However, the impact of this price rise on UK import expenditure will depend upon the price elasticity of demand for imports. If the demand for imports is price inelastic, a rise in import prices will lead to an increase in import expenditure, which will worsen the current account balance, not improve it. The same principle applies to exports. A fall in the exchange rate will definitely cause export prices to fall. However, the impact on export income will depend upon the price elasticity of demand for exports. Cutting price on a product that has a price inelastic demand will always result in a fall in total revenue. Therefore, if the price elasticity of demand for UK exports is price inelastic, a fall in export prices will lead to fall in UK export income. To benefit from a weaker currency the UK will need to have a price elastic demand for both its exports and imports. The most important factor that affects the price elasticity of demand for any product is the availability of substitutes. In general if there are few substitutes available, demand will tend to be more price inelastic than if there are many substitutes available. The low price elasticity of demand for imports in the UK has probably been caused by deindustrialisation. Deindustrialisation has reduced the number of domestically-produced substitutes available for British consumers to choose from. The UK used to produce manufactured goods like televisions, shoes and clothes. Today, manufacturing contributes less than 15% of GDP. Most of the manufactured goods that we buy are imported. If the price of these imported goods goes up, UK consumers can not respond by switching to a domestically produced alternative because there are not any. As a result, most consumers choose to carry on buying the import despite the price increase, creating a price inelastic reaction. The same principle applies to UK exports. Theoretically, UK exporters should benefit from a weaker currency. However, we can only benefit if we have goods to export! The UK economy needs to re-discover manufacturing.
Topic 7
84
Unfortunately the fall in the value of sterling has yet to create the boost in UK export income, or fall in import expenditure, anticipated by the Keynesians who advocated policies like quantitative easing, designed to weaken sterling. Figure 3: The falling pound sterling
Source: http://uk.finance.yahoo.com/currencies/converter/#from=GBP;to=EUR;amt=1
Figure 4 shows how the fall in the value of the pound affected UK import prices. A weaker currency drove up the price of UK imports by over 20%. Higher import prices caused UK firms to raise their prices. The cost-push inflation created by the fall in the value of the pound quickly eroded the competitive benefits of a weaker currency. The Bank of Englands decision to cut interest rates to 0.5% and to print 200bn via quantitative easing has backfired. From 2008 onwards the Bank of England has struggled to keep inflation below target. The inflation created by artificially low interest rates and money printing has reduced the UKs international competitiveness!
Crisis Economics: The Cutting Edge Topic 7 85
Figure 5: UK Trade
Source: http://www.statistics.gov.uk/cci/nugget.asp?id=199
The fall in the value of sterling engineered by the Bank of England has so far failed to deliver the export-led recovery that was anticipated by the Keynesians. Figure 5 shows the UKs trade deficit. The fall in the value of sterling has not improved the UKs trade balance. The income generated from the sale of UK exports is still insufficient to cover the amount spent by the UK on imported goods. The data shows that a falling exchange rate has not fixed the UKs international competitiveness problem. In addition to the handicap of high domestic inflation, many UK firms struggle to compete against their foreign rivals because they sell poor quality goods. A weak pound might, until inflation kicks in, at best help to create a temporary price advantage for UK firms. However, a weak currency will not help UK firms to overcome non-price factors that hold back the countrys international competitiveness
2. External factors
The economies that suffered most from the global financial crisis were those that had relied most on debt. During the boom years households in America, and much of Europe, used credit to boost consumption, creating short-run economic growth (see Topic 3 and Topic 5). Sadly, when credit disappeared aggregate demand in these countries crashed, leading to a sharp recession. In the circumstances it seemed unlikely that a recovery could be based around a recovery in domestic consumption; it would take households years to pay down their debts. To generate the increase in aggregate demand required to create a recovery, policy makers tried to stimulate exports. To create an export-led route out of recession central banks pursued policies that were designed to weaken their currencies. Countries that tried this approach encountered two problems. The first problem was that other countries were trying to do the same thing. The global financial crisis crunched the demand for goods and services across the developed world. As a result firms in countries such as Britain found it difficult to export because the credit crunch had decimated markets across the developed world. It is difficult to export if nobody is buying! And secondly, it was difficult for countries such as Britain to create a weaker currency because other countries were trying to do the same thing at the same time. For example, policymakers in most highly indebted countries in the developed world have also embarked upon programmes of quantitative easing, and interest rate cuts.
Crisis Economics: The Cutting Edge Topic 7 86
Topic 7
87
Supporters of the euro argue that a single currency creates price transparency within the Eurozone, which enhances competition, leading to greater efficiency. In addition, the euro also eliminates exchange rate risk, encouraging firms within the Eurozone to trade with one another. The UKs decision to retain sterling means that the UK has, almost certainly, failed to make the most of the opportunities created by the Single European Market. Critics of the single currency argue that the British government has been right in its decision to keep the U.K. out of the Eurozone. In practice, the ECBs one size fits all approach to monetary policy has failed because the Eurozone is not an example of an optimum currency area. Some countries within the Eurozone have failed to abide by the rules of the Stability and Growth Pact (SGP). Countries such as Greece have accumulated huge national debts, which they may struggle to service in the future. In the future the EU may have to tighten up the rules of the SGP in order to reduce the risk of a Eurozone member state from defaulting on its sovereign debt.
1. Discuss the arguments for and against the UK joining the single currency. 2. Some economists argue that central banks should combat recession by creating an export-led recovery by pursuing policies that are designed to create a fall in the exchange rate. Evaluate the arguments for and against this approach. 3. Discuss the arguments for and against imposing stricter fiscal rules on Eurozone governments.
Topic 7
88
Source: http://www.hm-treasury.gov.uk/d/public_finances_databank.xls
Topic 8
89
A Word of Warning
Estimates of the relative size of the structural and the cyclical components of the fiscal deficit are exactly that: estimates. Until the UK economy recovers nobody will know just how big is the UKs structural deficit. Figure 1: The UKs Fiscal Crisis 2010 and Beyond (structural fiscal deficit as a percentage of GDP)
In 2009 the OECD forecast that the UKs structural fiscal deficit was equivalent to nearly 10% of UK GDP, which is above the 6% forecast for the Greek economy. Structural fiscal deficits are not self-curing. In 2010 the Greek government found it very difficult to impose fiscal austerity on the Greek people, who responded to tax increases and public sector spending cuts by rioting and going on strike. The new UK Conservative / Liberal coalition government elected in May 2010 pledged to make even bigger cut backs and tax increases.
Crisis Economics: The Cutting Edge Topic 8 90
It remains to be seen how the British people will react to fiscal austerity, when it finally arrives.
Fiscal Rules
Fiscal rules are promises that the government has publicly made regarding the annual fiscal balance and the overall scale of the national debt. Fiscal rules were designed to avoid the type of fiscal crisis that the UK economy is now suffering from. The UK government has run fiscal deficits twenty-five times in the last thirty years. Governments run fiscal deficits during years when tax income falls below government spending. Governments finance fiscal deficits by borrowing. The government borrows by selling bonds. When governments run fiscal deficits the national debt rises. The national debt is the total amount owed by the government to its bondholders. The annual fiscal deficit should not be confused with the national debt. For example, during the 2010 election campaign New Labour politicians pledged that, if re-elected, a new Labour government would, halve the deficit within four years. This pledge was widely misinterpreted as a promise to halve the stock of public debt, i.e. the national debt. To reduce the national debt the government must run an annual fiscal surplus. The promise to halve the deficit was a guarantee that the government was still planning to increase the national debt over the next four years. Halving the deficit means halving the rate of growth of the national debt.
In effect the golden rule was a promise to the bond markets that the UK would not increase the national debt over the duration of the economic cycle. The only exception to the golden rule was government borrowing to fund capital investment, which was considered to be acceptable. The government will only borrow to invest and not to fund current spending. Borrowing to invest is acceptable because it is sustainable, unlike borrowing to fund current consumption. Public investments should create a larger economy. A larger economy will help the government to raise more in taxation. The extra taxation can then be used to pay the interest on the money borrowed to fund the investment. In other words, over the ups and downs of an economic cycle the government should only borrow to pay for investment that benefits future generations. Day-to-day (current) spending that benefits todays taxpayers should be paid for with todays taxes, and not with borrowed money, which increases the national debt that future generations have to service. Figure 3: The Economic Cycle
The golden rule offered Gordon Brown some flexibility regarding the operation of fiscal policy. Keynesians believe that recessions are caused by a lack of aggregate demand in the economy. To counter the recession the government should use policies that are designed to increase the level of aggregate demand, an example being expansionary fiscal policy. The golden rule justified the use of expansionary fiscal policy during recessions. In the short run the national debt might increase. However, the budget would still remain balanced over the duration of the economic cycle if the government ran fiscal surpluses during the boom phase of the cycle. These surpluses would pay down the debts that were built up during recession.
Crisis Economics: The Cutting Edge Topic 8 92
Higher levels of investment will create an increase in the economys long-term trend rate of economic growth. Some economists claim that Gordon Browns fiscal rules were critical in enabling the NICE decade.
2. Low inflation
New Classical economists that believe in the theory of monetarism argue that inflation is always and everywhere a monetary phenomenon. Inflation arises during periods when the money supply grows at a faster rate then the economy. To control inflation monetarists argue that the government must reign in the growth of the money supply to match the rate of growth of national output. Monetarists argue that the scale of the fiscal deficit affects the rate of growth of the money supply. Government bonds are a broad form of money. If the government runs a huge fiscal deficit the government will have to issue bonds to raise the finance needed to fund the deficit. Printing more government bonds will increase the broad money supply, which will increase the risk of inflation. History tends to support the link between fiscal policy and inflation. Periods of high inflation are normally preceded by wars. Most wars are financed via huge fiscal deficits. Fiscal deficits increase the supply of government bonds, which increases the broad money supply. A rapid increase in the money supply causes inflation. Fiscal rules encourage a more prudent approach towards fiscal policy. For example, the EUs decision to cap annual fiscal deficits at just 3% of GDP limits the amount of new bonds that governments are able to issue each year. Limiting the amount of bonds that can be issued helps to restrict the rate of growth of the money supply, making inflation less likely.
Fiscal rules that constrain the stock of public debt also help to keep interest rates low. If the national debt is allowed to grow too large relative to GDP of the country the risk of default rises. Governments default when they refuse, or are unable, to pay the interest that is due on their government bonds. Debt as a percentage of GDP measures the affordability of a nations national debt. The risk of default rises when debt rises relative to the size of the economy because the government will find it harder and harder to raise the tax incomes needed to pay the bond interest due. If the perceived risk of a sovereign default rises the demand for a countrys government bonds will fall. In the circumstances governments that want to carry on running fiscal deficits must offer higher rates of interest on their bonds in order to compensate investors for the additional risk of buying bonds that are more likely to default. If the total stock of public debt remains low, relative to GDP, the debt will remain affordable. As a result the perceived risk of a default will remain low. If the perceived risk of a future default stays low the government should be able to finance its fiscal deficits at a relatively low rate of interest. Low rates of interest benefit firms and consumers. However, low rates of interest also benefit the taxpayer too because they reduce the cost of servicing the national debt. If debt servicing costs fall the government will be able to spend a greater percentage of the countrys tax income on public services, such as health care and education. Countries that break their fiscal rules might find themselves spending more on debt interest each year.
Governments that want to expand the output of the public sector will have to increase government expenditure. In the long-run, the extra government expenditure will lead to higher tax rates. If tax rates rise, household disposable incomes will fall. If disposable incomes fall, consumption across the economy will also fall. A fall in private sector consumption will shrink the size of markets in the private sector. If the number of spending votes cast into the private sector falls, private sector output must also fall too. In practice most governments that try to expand the role of the state do so via fiscal deficits. To finance fiscal deficits the government has to borrow from the private sector by selling bonds. If the government increases the amount that it borrows there will be fewer funds available for firms in the private sector to borrow. The shortage of investment funds available for the private sector will drive commercial rates of interest up. Higher rates of interest will lead to a smaller private sector because higher rates of interest will reduce the levels of both private sector consumption and private sector investment.
6. Intergenerational equity
The phrase intergenerational equity means fairness across the generations. Fiscal rules facilitate intergenerational equity because they restrict a governments ability to provide high quality public services that benefit the current generation that have been financed via debt that future generations will be obliged to service and pay back. Politicians realise that the best way to stay in power is to provide high quality public services without raising taxation to pay for these services. In the absence of fiscal rules politicians might be tempted to finance better public services by taking on debt, rather than by raising taxes. Governments try to borrow over relatively long periods of time - 25 years or more. Therefore, future generations will have to pay additional taxes to pay the costs of servicing the debt that was taken on to finance the public services that their parents generation enjoyed. It could be argued that it is morally wrong for future generations to be asked to pay more in tax for public services that they never had the opportunity of consuming.
Crisis Economics: The Cutting Edge Topic 8 96
Disadvantages of Fiscal Rules 1. Fiscal rules impose a fiscal straightjacket on policy makers
Keynesian economists argue that recessions are caused by a lack of aggregate demand. Governments should not stand back and allow the economy to remain in equilibrium with a huge negative output gap. Instead, the government must intervene and use reflationary demand side policies such as expansionary fiscal policy and/or slack monetary policy. Reflationary policies that increase the level of aggregate demand in the economy will increase the equilibrium level of output and employment, moving the economy out of recession. According to Keynesians the economy is not self-regulating. The economy will remain in recession if aggregate demand remains low and stable. Fiscal rules are opposed by some modern Keynesian economists, such as Professor David Blanchflower because they might limit the fiscal deficit that policy makers might wish to deploy in order to get the economy out of recession. For example, in the Eurozone governments must promise to keep their annual fiscal deficit below 3% of GDP. During a severe recession Keynesians might argue that a fiscal stimulus of just 3% might not be enough to provide the demand-side push required to create a healthy recovery. Figure 4: The constraint of fiscal rules
In Figure 4 initially, before the recession struck the economy is portrayed as being in equilibrium producing an output of NY1 because aggregate demand was stable at AD1. The recession decreases the level of aggregate demand from AD1 to AD2. As a result the equilibrium level of GDP crashes from NY1 to NY2. To counteract the recession Keynesian policy makers would recommend a fiscal stimulus which would increase the level of aggregate demand from AD2 back to AD1. If this policy can be enacted the equilibrium level of national income would re-bound from NY2 back to NY1. Critics of fiscal rules argue that overly strict fiscal rules might prevent policy makers from running the fiscal deficit needed to increase aggregate demand from AD2 to AD3. For example, the EUs fiscal rule that annual deficits must be capped at 3% of GDP will limit the scale of the fiscal stimulus that policy makers can impose on the economy. A deficit of just 3% of GDP might only be enough to increase aggregate demand from AD2 to AD3. An increase in aggregate demand of this magnitude will produce an unsatisfactory, anaemic recovery; the increase in the equilibrium level of GDP is just NY2 to NY3.
Crisis Economics: The Cutting Edge Topic 8 97
The UKs fiscal rules do offer policymakers greater flexibility to counter recessions via expansionary fiscal policy. Unlike the EU, the UK has not made a fiscal promise to limit the annual fiscal deficit to 3% of GDP. The nearest UK equivalent is the golden rule. Theoretically, policy makers in Britain would be permitted to run an annual fiscal deficit of 10% to counter recession, and still be able to meet the golden rule promise to balance the budget over the duration of the economic cycle. Keynesians like David Blanchflower argue that policymakers in Europe have a deflationary bias. The EUs stability and growth pact fiscal rule that limits a countrys annual fiscal deficit to just 3% of GDP is too restrictive and overly prudent. The opportunity cost of this prudence is that during recessions fiscal policy measures might lack the power to move the economy out of recession. In contrast, the UKs fiscal rules are far less restrictive, and therefore, preferable.
Source:http://seekingalpha.com/article/117374-u-k-debt-burden-from-current-crisis-to-last-20years
Topic 8
98
During Gordon Browns time as Chancellor the Treasury increased the length of the economic cycle several times over the last few years, which, conveniently, had the effect of helping the government to meet its golden rule! Figure 5 shows that during the period from 1980 to 2008 the UK government only managed to run a fiscal surplus on five occasions. If policymakers break the fiscal promises that they have made the government will lose credibility will the all important bond market. Governments that allow the national debt to get out of control run the risk of default. To compensate for the additional risk of holding government bonds higher rates of interest will need to be offered to investors. In 2009 the UK government tried to re-assure the bond markets by passing the Fiscal Responsibility Act. This new fiscal promise pledged that the next government would halve the annual fiscal deficit in four years. It remains to be seen whether the bond market will be influenced in a favourable manner by this new fiscal promise. Will the bond markets trust the UK government to take the actions required to meet this promise, or will the government continue to break its promises? In the Eurozone fiscal rules have been poorly enforced. In theory the EU has the power to fine member states that break the rules of the stability and growth pact. Unfortunately, some member states that have broken the rules have failed to pay their fines, creating a moral hazard. Over time more and more member states have elected to break the stability and growth pact rules because they know that the EU will not penalise them effectively. There have also been allegations that some member states have only managed to stay within the rules by using creative fiscal accounting. For example, the Greek government hired the American investment bank, Goldman Sachs to hide part of its national debt off balance sheet in order to qualify for Eurozone membership.
http://www.spectator.co.uk/coffeehouse/2532196/the-debt-adds-up.thtml
Topic 8 99
Topic 8
100
Policymakers in Europe face a very difficult decision. On the one hand it is now fairly clear that the EU needs to impose fiscal discipline on more profligate member states if the single currency is to survive. However, imposing a European Commission veto on an elected governments tax and expenditure plans would be undemocratic. The single currency has been a force for both economic integration and globalisation. Consumers (lower prices) and shareholders (higher profits) have benefited from globalisation. Preserving the single currency might help to boost trade and facilitate economic growth in the euro zone. The question is whether these material benefits are enough to outweigh the non-material costs of a loss of national sovereignty over fiscal policy. The benefits, in terms of economic development, of a truly democratic national parliament should not be underestimated.
Topic 8
101
A fiscal deficit occurs when a government spends more than it collects in taxation. Governments that run fiscal deficits have to borrow the shortfall by selling interest bearing bonds. If a government runs a fiscal deficit, the total stock of debt owed by the government, the national debt, will rise. Therefore, the promise made by Gordon Brown in spring 2010 to, halve the deficit over the next parliament was actually a commitment to increase the UKs national debt! Halving the annual fiscal deficit just halves the rate of growth of the national debt. The fiscal deficit can be split into two components: the cyclical and the structural deficit. The cyclical deficit is that part of the budget deficit caused by a downturn in the economic cycle. This is because during recessions, when unemployment rises, tax revenues tend to fall and welfare expenditure tends to rise. The structural deficit is that part of the fiscal deficit that cannot be attributed to a recession. A high proportion of the UKs fiscal deficit is, almost certainly, structural. Structural deficits are created by politicians who attempt to buy votes by promising better public services without the tax increases needed to pay for these improvements. Fiscal rules are promises or pledges made by politicians to restrict the annual fiscal deficit and to control the rate of growth of the national debt, making the risk of default less likely. Fiscal rules are designed to reassure bond markets. If the buyers of government debt believe that politicians are committed to their fiscal rules they should be willing to lend to these governments at lower rates of interest. Lower rates of interest will enable politicians to devote a greater proportion of tax income to public services, rather than to debt interest. Keynesian economists tend to be less enthusiastic about fiscal rules because they limit the flexibility of policy makers to counteract recession. During recessions, Keynesians believe that governments should run fiscal deficits to increase the level of aggregate demand. If fiscal rules are too strict the government might struggle to engineer the fiscal stimulus needed to push the economy out of recession. In recent times policy makers have ignored their own fiscal rules, running up huge national debts. For example, Gordon Brown completely ignored his own pledge to balance the budget over the duration of the economic cycle. During the boom years when the government should have been running fiscal surpluses, Brown elected to run deficits. Fiscal rules will only be effective if they are credible. In principle, fiscal rules should create a degree of intergenerational equity: fairness between the generations. Browns decision to ignore his own fiscal rules for short-run political gain will impose financial pain on future generations. These future generations will be asked to pay higher taxes in order to service and pay off the debts built up to finance the lavish public services and pensions provided for the baby-boomer generation.
1. Distinguish between a structural and a cyclical fiscal deficit. 2. During the 2010 general election Gordon Brown promised that, if re-elected, his government would halve the fiscal deficit during the next parliament. Many members of the public, and even journalists, misunderstood this pledge, believing that Brown had promised to reduce the UKs national debt. Explain this error. 3. Should policymakers disregard their own fiscal rules? 4. Discuss the case for and against stricter fiscal rules in the eurozone.
Topic 8
102
Table 1 shows that the rate of increase in consumer prices fell for over a year. This is not the same as deflation. It is important to note that throughout this period prices were still increasing. As a result, the internal purchasing power of money in the UK also fell. In other words, 1 in 2008 bought more goods and services than 1 in 2009. Falling inflation should never be described as deflation! Some commentators also mistakenly refer to falling asset prices as deflation. Falling asset prices are falling asset prices. On their own, falling asset prices do not constitute deflation. Deflation is the fall in the average price level.
Topic 9
103
Austrian economists view deflation as being a situation where the money supply contracts. If the money supply shrinks at a faster rate than the economy the result will be a fall in the average price level, assuming that the money supply circulates around the economy at a constant rate. In March 2008 the Bank of England announced that it was going to inject money into the economy by printing money. The Bank called this policy quantitative easing (For further discussion see Topic 6). The money printed has been used by the Bank of England to buy government bonds. By February 2010 the Bank of England had printed over 200bn of cash, which doubled the UKs narrow money supply. Austrian economists would definitely not agree with the assertion that the UK economy has undergone a period of deflation. The reverse is true.
Did the UK economy suffer from deflation during the period 2008 2009?
The answer to this question depends upon the index used to calculate price inflation. The governments preferred measure of inflation prior to 2003 was the RPI (Retail Price Index). The RPI is a relatively broad measure of price inflation that includes housing related costs, such as mortgage interest, council tax and buildings insurance. The RPIX measure of inflation excludes mortgage interest payments only.
Crisis Economics: The Cutting Edge Topic 9 104
In 2003 the government changed the official measure of inflation. The new measure of inflation adopted was the CPI (Consumer Prices Index). The CPI is a much narrower measure of inflation that excludes all the housing-related costs that are included within the RPI. During the housing boom that ended in mid-2008, CPI inflation lagged behind RPI inflation. Rampant house price inflation certainly increased the cost of living for many UK households. However, due to a political decision made by the government this inflation was masked from the official figures. At this time the media studiously chose to ignore the rise in RPI inflation created by rising house prices. Inflation was only thought about from the point of view of the CPI. The onset of the credit crunch in 2008 led to a period of credit contraction. This contraction of credit decreased the demand for housing, causing the property bubble to burst. Figure 1 shows that from September 2008 onwards the rate of CPI inflation declined. However, the rate of RPI inflation fell at a much faster rate than CPI inflation because at this stage house price inflation was strongly negative. According to the Nationwide the average price of a house in the UK at the end of 2007 was 184,000. One year later, the same house cost 150,000 - a fall of nearly 19%. The weighting given to housing-related costs in the RPI is relatively high, which magnified the effects of falling house prices on this measure of inflation. In February 2009 the RPI turned negative. At that time media interest in the RPI, which had been studiously ignored since 2003, was mysteriously re-born. The headlines screamed alarm: the UK economy was suffering from deflation! But was this assessment factually accurate? The RPI stayed in negative territory until November 2009. Throughout this period of deflation the official rate of inflation, the CPI, remained positive. The government and most of the media seemed keen to promote the view that the UK was suffering from deflation, which was not strictly true. Figure 1: Different price indices in the UK
Source: www.statistics.gov.uk/CCI/nugget.asp?ID=19
If households respond to deflation in the way suggested by Keynesians, i.e. by saving a greater proportion of their income, private sector consumption will fall. Other things being equal, a fall in consumption will lead to a fall in aggregate demand. Keynesians believe that the level of aggregate demand determines the level of output and employment within an economy. If the general level of spending in the economy falls, sales will also fall too. In order to avoid the build up of unnecessary stock, firms are likely to respond to falling sales by reducing output and employment. Figure 2 shows that a fall in aggregate demand from AD1 to AD2 will lead to a fall in the equilibrium level of national income from NY1 to NY2 and a fall in the level of employment from E2 to E1. Figure 2: Deflation
However, is this nightmare scenario likely? Will the fear of deflation really cause consumers to postpone purchases? In practice, consumers are not put off by the prospect of lower prices. Take the market for consumer electronics. The price of HD TVs, mobile phones and computers have been deflating for years. Furthermore, consumers expect prices to carry on falling in the future too due to technological advances. Consumers also expect future improvements in product quality and functionality too. Despite this consumers do not respond in the way predicted by the deflationists. In practice households do not postpone their purchases. Instead households buy a new TV or computer whenever they are needed. Households know full well that the price of an I-Pod will fall in the future. They also know that the next generation I-Pod will be better than the current one, but that does not seem to put them off buying today. Deflation does not cause consumers to postpone their purchases. This argument is one of many deflationary myths. A second reason why deflation is feared relates to debt. During periods of deflation prices fall, including the price of labour: wages. If wages fall existing debts will be harder to service. If debt servicing costs form a higher percentage of wages, disposable incomes will fall.
Crisis Economics: The Cutting Edge Topic 9 106
If disposable incomes fall, consumption is likely to fall too, pushing down on aggregate demand. According to Keynesians a fall in aggregate demand will push the economy into recession. During recessions national income falls. Falling incomes will increase the burden of debt a second-time. Indebted households will be forced into cutting expenditure again, creating the dreaded debt-deflation spiral. A debt-deflation spiral would be extremely bad news for a highly-indebted economy such as the UK. However, UK households can rest easy in the knowledge that there has never been a sustained period of deflation in an economy running a fiat currency. Central bankers wont let it happen! In practice the reverse is true. History shows that central banks such as the ECB, Federal Reserve and our own Bank of England have an inflationary bias. Central banks actively go out to create inflation, especially in countries that have a debt problem. Why? Inflation reduces the real value of debt. Central banks create inflation by expanding the money supply faster than the economy. In the past when the worlds major currencies were backed by either gold or silver central banks found it hard to expand the money supply quickly because extra precious metal would have to be acquired to back every extra note and coin in circulation. The switch to fiat currency that occurred when the gold standard broke down removed this problem. Fiat currencies are not backed by precious metals, such as gold or silver. Fiat currencies gain acceptance by government decree. Today all of the major currencies of the world are fiat currencies. According to Federal Reserve chairman, Ben Bernanke, deflation is easily avoided. Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost... We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.1 History shows that deflation has only ever occurred in economies that have had commodity, rather than fiat money.
Japanese deflation
Deflationists frequently quote the example of Japan in the 1990s to prove that deflation is possible in an economy operating with a fiat currency. The only problem is that the facts do not entirely back up this assertion. Figure 3: The economy of Japan: the CPI index
Source: http://www.econstats.com/r/rjap_aa20.htm 1 Comments made by Ben Bernanke during a speech to the National Economists Club, Washington DC, November 21st 2002. www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021121/default.htm Crisis Economics: The Cutting Edge Topic 9 107
Figure 3 shows that the Japanese economy experienced mild negative CPI growth during the period from 1998 until 2003, and again during 2008 -2009. However, the data also shows that the average price level in Japan actually rose during the whole period, i.e. 1991 - 2009 by 3.4% (100.6 97.3 * 100). So during Japans lost decade(s), there was actually more inflation than deflation! The yen is not backed by precious metal or anything else. It is a fiat currency. If this is the best example of deflation in a modern economy, running a fiat currency, the deflationists need a better example. During Japans lost decade Japanese asset prices certainly crashed. Take the value of Japanese companies: the Nikkei share index peaked in 1990 at nearly 39,000. By 2003 the same index stood at 7,600, a drop of over 80%. The fall in Japanese property prices was even more dramatic, which fell between 50 and 90%, depending on the area. However, to reiterate, falling asset prices, on their own, do not constitute deflation.
Conclusions
In recent years central banks, including the ECB, have operated with an inflationary bias. Policies such as quantitative easing and zero interest rates have increased consumer prices. These same policies have also managed to put a floor under asset prices, such as housing and shares, which were in danger of collapsing from their bubble levels. Preventing further falls in house prices is seen as being important in order to prevent further bad debts for Britains commercial banks. The UKs national debt is at a record peacetime high. Fortunately for the UK, the government has been able to borrow in our own currency. After WWII the UK government used inflation successfully to reduce our debt burden. It seems likely that the UK government will try to inflate away our debts again. At the same time the bogus threat of deflation has been used to keep UK interest rates artificially low, which has reduced our debt servicing costs. The City has also been instrumental in creating deflationary hype. The UK banking sector has been the major beneficiary of quantitative easing, a policy justified by the false threat of deflation.
Topic 9
108
Deflation occurs when the average price level across the economy falls. Historically, deflation is an extremely rare event for any economy running a fiat currency. Instead, inflation, which occurs when the average price level rises, is very much the norm. Deflation increases real wages, enabling workers to enjoy a higher standard of living. However, Keynesians argue that deflation encourages consumers to postpone consumption, leading to lower levels of aggregate demand, and ultimately, recession. In practice it is not certain whether consumers really do respond to deflation by postponing consumption. To combat the perceived threat of deflation in Britain and the USA central banks have slashed interest rates and printed money via a policy called quantitative easing.
1. Distinguish between fiat and commodity money. 2. Explain why inflation is more common than deflation in economies that operate with fiat currencies 3. Some economists believe that inflation measurements that rely upon price indices are unsatisfactory because they are, to a large extent, subjective. Do you agree or disagree with this view? How else might inflation be measured apart from price indices? 4. The UK is a highly indebted economy. What problems might deflation create for an economy that has very high levels of public sector and private sector debt? 5. According to Federal Reserve chairman Ben Bernanke central banks can prevent deflation by printing money. Discuss whether Ben Bernanke is right. Is deflation always preventable?
Topic 9
109
Topic 10
110
Figure 1 shows a world divided according to current account balances. One half of the world are net producers and net savers. These creditors run current account surpluses and are shown in orange on the map. Creditor countries like China and Germany run current account surpluses. The other half of the world is shown in green. These debtor countries are net consumers and borrowers. Debtor countries like Britain and the USA run current account deficits.
13.5
Source: www.vig.pearsoned.co.uk/catalog/uploads/Griffiths_C01.pdf 1 www.telegraph.co.uk/finance/economics/7721166/UK-trade-deficit-widens-sharply.html Crisis Economics: The Cutting Edge Topic 10 111
Fortunately, the UK does run a small invisible surplus because the UK exports more services than it imports. The UKs main service exports are City related activities, such as banking, accounting, insurance and other financial services. However, the invisible surplus generated by the City, which in March 2010 was 3.8bn, is well below the amount needed to avoid a current account deficit. During the first wave of the financial crisis (2008-2009), the Bank of England responded to the threat of depression by cutting interest rates sharply. As a result, hot money flowed out of sterling and the exchange rate fell by at least 25% against most currencies. Theoretically, a fall in the exchange rate should have helped the UK economy to recover because a weaker exchange rate will make imports more expensive and exports seem cheaper. Unfortunately, the anticipated export-led recovery created by a weaker currency has thus far failed to occur. The structural imbalances within the UK economy have held it back. For example, it is very difficult to benefit from a weaker currency if the domestic manufacturing sector is relatively small.
Debtor Countries
Figure 2 shows the UKs current account balance as a percentage of GDP over the period 1980 to 2009. Unfortunately, for the UK economy import expenditure has exceeded export income for the majority of this period of nearly thirty years. Furthermore, the scale of the deficits has, for most of the time, been huge too. Some economists believe that current account deficits are not a cause for concern, so long as the country concerned has borrowed in order to purchase capital goods. Borrowing money from abroad to fund investment should boost the productivity of labour. The additional economic growth created by the rise in productivity should boost the GDP of the country that has run the current account deficit. The increase in GDP will hopefully create the additional income required by the debtor to pay the interest on the debt that has been taken on.
Crisis Economics: The Cutting Edge Topic 10 112
Source: www.statistics.gov.uk
Unfortunately, over the last 30 years, most of the money borrowed by UK households, firms and the government has been borrowed to finance consumption, rather than productive investment. For example, the securitisation of the UK mortgage market enabled British financial institutions to raise cash by selling off a considerable part of the UKs owner occupied property stock (an asset) to overseas buyers; the bulk of the mortgage-backed securities raised on UK property were bought by overseas buyers. Borrowing in order to finance the consumption of imported goods creates a temporary improvement in the material standard of living. Unfortunately, this improvement in the standard of living will only be temporary because debt has to be paid back with interest. Borrowing to finance the purchase of consumer goods will always be unsustainable because, unlike capital goods, consumer goods do not create an income for the owner of the good that can be used to pay the debt and interest due. Those that choose to borrow in order to consume effectively pull forward future consumption into the present. When the debts and the interest fall due, those that have borrowed in order to consume will have to accept a lower disposable income. Unlike an imported capital good, a flat screen TV or a German car will not generate an income, creating a repayment problem for those that chose to borrow in order to consume. Thirty years ago the bulk of the funds lent out by UK banks originated from the pockets of UK savers. Over time this situation changed as the banking system became globalised. Today, most of the UKs banks are highly geared. This means that a very high percentage of the capital employed by UK banks has been borrowed from foreign creditors, mostly foreign banks, located in creditor countries that run current account surpluses, where there is a surplus of saving. Some economists have claimed that a current account deficit is a sign of economic strength, even if most of the borrowing undertaken is to finance imported consumer, rather than imported capital goods! Keynesian economists following this line of thought would argue their position by stating that the high levels of domestic demand that are sucking in imports are a sign of strength, not weakness because high levels of aggregate demand tend to be associated with healthy economies that have high levels of output and employment.
Crisis Economics: The Cutting Edge Topic 10 113
Furthermore, during boom periods, when domestic aggregate demand is high, policy makers should not be overly concerned about a growing current account deficit because most of this deficit will be cyclical, rather than structural. Cyclical current account deficits are caused by economic booms. The structural current account deficit is that part of the current account deficit that cannot be attributed to an economic boom. Unfortunately for the UK a very high percentage of our current account deficit is structural, rather than cyclical, reflecting deep seated supply-side weaknesses within our economy. For example, during the decade long debt-fuelled Brown boom the UK economy still managed to run huge current account deficits. The UK as a nation has lived beyond its collective means for far too long, selling off assets and taking on liabilities from overseas creditors in order to raise the funds needed to import more consumer goods than we export. The UKs persistent current account deficit explains why most of the UKs banks are highly geared. UK banks have fed credit hungry households by borrowing from foreign banks located in countries where the savings ratio is much higher. Persistent current account deficits also explain why UK households are so heavily in debt. According to figures collected by the charity Credit Action in May 2010, the average UK household that has some form of unsecured consumer debt, such as a credit card or personal loan, owes over 18,000. A very high percentage of this borrowed money will have been spent on imported consumer goods, contributing towards the UKs trade deficit. The UKs current account deficit also explains why the UK is forced to sell off successful British businesses, such as Cadbury, Abbey National and Manchester United. The cash generated from these asset sales has enabled the UK to enjoy imported consumer goods that it otherwise would not have been able to afford. Over time, debtor countries like the UK and the USA make themselves poorer in the long-run as a result of their decision to live beyond their means today.
Creditor countries
At the same time as countries, such as Britain, America and Spain were running huge current account deficits, other countries, such as China, Germany and Japan were running huge current account surpluses. Countries that run a current account surplus export more than they import. As a result these countries generate more than enough export income to pay for their import expenditure. Countries that run current account surpluses tend to have higher savings ratios than countries that run current account deficits. The savings ratio measures the proportion of GDP that is saved. The savings ratio in China is 0.4, implying that households in China, on average, save 40% of their incomes. Income can either be saved or spent. A high level of saving therefore implies a relatively low level of consumption. These low levels of consumption have helped to reign in Chinas demand for imports. In addition, in China wages form a relatively low percentage of GDP, which also constrains domestic demand, and hence import expenditure (See Topic 3). Much of the funds lent to British and American banks came from the savings made by households in the creditor countries. Figure 3 shows Japans current account balance over the last 30 years.
Topic 10
114
Countries like Germany, China and Japan that run a current account surplus use the wealth created from their international competitiveness to purchase overseas assets and /or to pay off external debt owed to foreign creditors. In the last decade famous name companies such as Jaguar; van maker, LDV; and Vodaphone, that were once British owned, have all been sold off to foreign buyers. The profits generated from these assets flow abroad to shareholders living in creditor countries, boosting their incomes and living standards. In addition to physical assets, creditor countries have also used their surplus incomes from foreign trade to make interest bearing loans to British companies and households (via loans carried out via international money markets to UK banks). Again, the interest income paid by UK nationals to our foreign creditors will boost incomes and living standards abroad at our expense. The Chinese government has used a significant proportion of its export income to purchase American government bonds. The US government sells bonds to finance its fiscal deficit. The bonds issued by the US government pay a fixed rate of interest each year, which will create a currency inflow on Chinas financial account. These currency inflows will add to Chinas national income, adding to the material standard of living there. China is the number one holder of US government debt. The total amount owed by the US government to the Chinese is nearly $900bn. A debt this large is difficult to service, even for an economy that is as large as the US. Some economists have cast doubt on whether the US government will ability to raise the tax revenues required to pay the bond interest, and eventually the debt, owed to the Chinese. If the US government defaults, the bonds owned by the Chinese will become worthless.
Topic 10
115
When the Minsky moment arrives consumption will tend to fall; debtors will not be advanced new lines of credit if they are unable to pay the interest that is already due on their existing debts. If past consumption has been propped up by debt, a removal of debt will cause spending to fall. The Minsky moment for the debtor countries arrived in July 2007 when international credit markets suddenly froze. Why did the credit markets freeze? Throughout 2007 the number of American sub-prime mortgages falling into default rose steadily. When mortgages fall into default homeowners refuse to repay their mortgages. As a result the securitised assets based on these sub prime mortgages lost most of their value because they were no longer expected to deliver an income for the owner of the asset. Banks and other financial institutions in creditor countries acted rationally to this development by failing to buy new mortgage backed securities from American banks. Banks such as Northern Rock that relied upon international credit markets, rather than domestic savers, for loanable funds, found that they were unable to finance new mortgage lending and consumer credit. Most of the funds lent out by British banks to British households during the boom years did not come from deposits made by British savers. Instead, the credit came, via international money markets, from the savings made by people living in creditor countries such as China, Germany and Japan that run current account surpluses. The crunch reduced the availability and the price of consumer credit, which in turn led to a fall in aggregate demand. Firms responded to the build up of stock caused by the fall in aggregate demand by reducing output and employment, creating a recession.
The credit crunch is (part of) the solution, not the problem!
Misguided politicians on both side of the Atlantic have argued that the economic crisis will be resolved once the flow of consumer credit is resumed. Nothing could be further from the truth. For debtor countries such as Britain the problem has been too much, rather than too little, credit.
Crisis Economics: The Cutting Edge Topic 10 116
The persistent current account deficits run by the British economy over the last 30 years indicates that we, as a nation, have lived beyond our collective means for too long, explaining Britains record levels of debt. To recover the UK will need to produce more and consume less. The UK economy also needs to be re-balanced. For too many years the UK economy was overly dependent on the tertiary sector. During the NICE decade interest rates were kept too low for too long. Low interest rates postponed the Minsky moment. In addition, low interest rates combined with relaxed lending standards, stoked up the demand for UK housing. Cheap and easy mortgage credit made a speculative bubble in UK property possible. In the long-term to create a more sustainable form of economic growth the UK economy will need to enlarge its secondary sector. By doing so the UK should be able to sell more exports, reducing our current account deficit. The government and the Bank of England should also pursue economic policies that encourage saving rather than speculation. Interest rates need to be increased sharply in order to discourage debt and speculation. Higher interest rates will also tend to encourage saving. The UK has gone through a prolonged period of using debt to live beyond its means. This long-period of credit expansion has now come to an end. According to the Austrian economist, Von Mises, periods of credit expansion are always followed by periods of credit contraction; eventually debts have to be re-paid! David Camerons assessment of the UK economy is probably accurate: a decade of austerity for the UK economy looks more than likely!
Topic 10
117
In the long-term the Chinese may simply decide to consume a greater proportion of the goods produced by Chinese industry, and export less to debtor countries, such as the US. The decision to consume a greater proportion of domestic output and to reduce exports will improve the standard of living in China at the expense of American living standards. According to Schiff, Why should we (America) expect a billion Chinese to carry on painting our fence and to also pay us for the privilege? That situation is going to end.
Topic 10
118
The UK has run a current account deficit for many years. This means that the UKs expenditure on imported goods and services has exceeded the amount of income that the UK has been able to generate from the sale of its exports. Countries like the UK finance their current account deficits by selling off assets and by borrowing from overseas. Overtime, countries like Britain that sell assets and take on debt to live beyond their means make themselves poorer, especially if the bulk of the deficit was created as a result of importing consumer, rather than capital, goods. Other debtor countries that have sold cows to buy milk include: USA, Spain, Ireland, Portugal and Greece. The liquidity (cash) needed to finance the current account deficits of the debtor countries came from the savings made by the creditor countries that have run current account surpluses for many years. Countries like China that run current account surpluses generate export earnings that exceed import expenditure. During the boom years creditor countries like China pursued an export-orientated economic growth. A high percentage of the goods produced in Chinas factories were exported to be consumed by Americans and Europeans. The money required to buy up these goods was, in part, supplied by the savings made by the workers in the creditor countries. The boom ended when debt levels in the debtor countries reached critical levels. Borrowing to consume is not a sustainable strategy because eventually the stock of debt owed grows too high relative to the borrowers income. When this happens the debt can no longer be serviced. The bad losses caused by defaulting borrowers in the US inflicted huge losses on the banking sector, which prompted the credit crunch. The world economy needs to re-balance. China can no longer rely on indebted consumers in the US and in Europe to buy its goods. In the future the creditor countries must consume more and save less. On the other hand, in debtor countries like the UK we must consume less and produce more, which will require a rise in our savings ratio.
1. Current account deficits arise when a countrys import expenditure exceeds its export income. Explain two ways in which a country might obtain the funds to live beyond its collective means. 2. Are current account deficits always undesirable? 3. Explain why living standards in debtor countries such as Britain and the US are likely to fall in the future, and why is the reverse likely to be true for creditor countries such as China? 4. Discuss the possible impacts of a rise in wage rates in China for the US economy.
Topic 10
119