Despite initially backing the government’s austerity drive back in 2010, the IMF have now produced a report stating that basically, the government should borrow an extra £10 billion to invest in infrastructure and business tax cuts. Only when the economy has escaped the repeated faltering attempts to recover, should it cut government spending and the deficit with confidence.

Plan B

1. Be willing to borrow an extra £10billion this year
2. Invest in public sector infrastructure. This will provide an injection of demand, create jobs and a positive multiplier effect. The increased government spending will help counter the continued weakness in private sector spending
3. Business tax cuts. The IMF argue tax cuts for business will create incentives for investment. (Closing the loopholes of Amazon, Google and Apple should be a very high priority)

In addition, the IMF suggest trying a different form of Quantitative easing. Buying assets other than government bonds. The purchase of government bonds haven’t really filtered through into the economy. Buying mortgage bonds or corporate bonds may do more to stimulate bank lending.

It’s not exactly, the most radical plan, but it makes much sense than the alternative of strangling the recovery and risking a continued period of low growth. The UK economy has seen several false dawns in the past five years. There is always a mix of data which allows people to cherry pick their favoured outlook. But, however, you look at the UK economy, the over-riding impression is of uncertain recovery, cery weak growth, and an economy that has been more or less stagnant in terms of GDP since 2007. There is a high cost of failing to reach escape velocity.There is a high benefit of escaping the cycle of stagnant growth.

The government is caught between timid efforts to boost economic growth, and timid efforts to reduce the budget deficit. Neither is really working. The problem is they lack the confidence to go for growth and let the recovery take care of the deficit.

Combined with a loosening of monetary policy, this creates the potential for a real recovery. This has been the main macro-economic objective since 2008, but unfortunately, it has often been relegated in importance.

Related

• Is austerity self-defeating?
• What is austerity

The post Plan B for the economy appeared first on Economics Blog.

• Public sector net debt was £1,185.3 billion at the end of April 2013, equivalent to 75.2% of GDP
• Source: ONS ¹ (page updated May  23rd 2013)

Annual Borrowing

• In  2011/12 public sector net borrowing (the budget deficit) – was £121 billion or 7.9% of GDP.
• In 2012/13 net borrowing is forecast to be £120.9 bn (7.8% of GDP)  - _{note: this excludes a £28bn transfer of Royal Mail pensions in April 2012 and  £6.4 bn because of transfer of funds from AFP, Q.E. The official figure including Royal Mail and AFP transfers is £ 80 billion (5.1% of GDP).}
  

• See also: UK budget deficit

Gross Government debt

Although it is a little confusing, a different debt statistic is also produced. Gross government debt is calculated in a different way and includes public sector debt plus some government liabilities, social security funds, and local government debt (see also: gross government debt)

• In 2012/13, gross government debt is forecast to be £1,412 bn or 90.3% of GDP ²
• In 2012/13, public sector net debt is forecast to be £1,186 bn or 75% of GDP.

If all financial sector intervention is included (e.g. Royal Bank of Scotland, Lloyds), the Net debt was £2311.6 billion (147.3 per cent of GDP (2012). This is known as the unadjusted measure of public sector net debt.

Recent History of UK National Debt

After a period of financial restraint, from mid 1990s, public sector debt at a % of GDP fell to 29% of GDP by 2002. From 2002 – 2007 , national debt  increased to 37 % of GDP. This increase in debt levels occurred  despite the long period of economic expansion; it was primarily due to the government’s decision to increase spending on health and education (see: Gov’t spending in this period). There has also been a marked rise in social security spending.

Since 2008, public sector debt has increased sharply because of:

• 2008-13 recession (lower tax receipts, higher spending on unemployment benefits) The recession particularly hit stamp duty (falling house prices) income tax and lower corporation tax.
• These cyclical factors have also exposed an underlying structural deficit. (deficit caused by spending greater than tax, ignoring cyclical factors)
• Financial bailout of Northern Rock, RBS, Lloyds and other banks.

Comparison With Other Countries

Although 73% of GDP is a lot, it is worth bearing in mind that other countries have a much bigger problem. Japan for example has a National debt of 225%, Italy is over 100%.  The US national debt is close to 75% of GDP. [See other countries debt]. Also the UK has had much higher national debt in the past, e.g. in the late 1940s, UK debt  was over 180% of GDP. Nevertheless, there are reasons why the UK couldn’t borrow the same sums that we did post-war.

History of National Debt

UK National Debt since 1900.

See also: Historical National debt

National Debt since 1922. Source: HM Treasury and UK Public Spending [1]

These graphs show that government debt as a % of GDP has been much higher in the past. Notably in the aftermath of the two world wars. This suggests that UK debt is manageable compared to the early 1950s. (note, even with a national debt of 200% of GDP in early 1950s, UK avoided default and even managed to set up the Welfare State and NHS. However, in the current climate, the UK wouldn’t be able to borrow the same as in the past.  For example, private sector saving is lower, and the US wouldn’t give us big loan like in the 1950s.

• How much can a government borrow?
• What are the prospects for UK debt default?

Debt and Bond Yields

Bond yields reflect the cost of borrowing. Lower bond yields reduce the cost of government borrowing.

Since 2007, UK bond yields have fallen. Countries in the Eurozone with similar debt levels have seen a sharp rise in bond yields putting greater pressure on their government to cut spending quickly. However, being outside the Euro with an independent Central Bank (willing to act as lender of last resort to the government) means markets don’t fear a liquidity crisis in the UK;  Euro members who don’t have a Central Bank willing to buy bonds during a liquidity crisis have been more at risk to rising bond yields and fears over government debt.

See also: Bond yields on European debt | (reasons for falling UK bond yields)

Cost of Interest Payments on National Debt

The cost of National debt is the interest the government has to pay on the bonds and gilts it sells. In 2011/12, the debt interest payments on UK debt are anticipated to be £48.6 bn (3% of GDP). This is a sharp increase from two years ago, but still quite manageable.  See also: UK Debt interest payments

As a % of GDP, debt interest payments are relatively low.

In 1985-86, debt interest payments reached 4.5% of GDP

How to reduce the debt to GDP ratio?

• Economic expansion which improves tax revenues and reduces spending on benefits like Job Seekers Allowance. The economic slowdown which has occurred since 2010 has pushed the UK close to a triple dip recession and therefore the further squeeze on tax revenues has led to deficit reduction targets being missed.
• Government spending cuts and tax increase (e.g. VAT) which improve public finances and deal with the structural deficit. The difficulty is the extent to which these  spending cuts could reduce economic growth and  hamper attempts to improve tax revenues. Some economists feel the timing of deficit consolidation is very important, and growth should come before fiscal consolidation.
• See: practical solutions to reducing debt without harming growth

What is the Real Level of UK National Debt?

It is argued by some that  the UK’s national debt is actually a lot higher. This is because national debt should include pension contributions and private finance initiatives PFI which the government are obliged to pay.

The Centre for Policy Studies (at end of 2008) argues that the real national debt is actually £1,340 billion, which is 103.5 per cent of GDP. This figure includes all the public sector pension liabilities such as pensions, and private finance initiative contracts e.t.c (and Northern Rock liabilities).

• However, these pension liabilities are not things the government are actually spending now. Therefore, there is no need to borrow for them yet. It is more of a guide to future public sector debt. I don’t accept the fact that future pension liabilities should be counted as public sector debt. In 2006, the Statistics Office did change calculations to include some PFI into public sector debt figures [pdf - Treasury.gov.uk]
• However, it is a sign that it will be difficult to improve finances in the future.

Another problem is that with the financial crisis, the government have added an extra £500bn of potential liabilities. Note: the Government has offered to back mortgage securities. They are unlikely to spend this money. But, in theory the government could be liable for extra debts of up to £500bn. If we include this bailout package as a contingent liability National debt would be well over 100% of GDP. However with a modest improvement in the bank sector, the necessity for these bailouts look unlikely, unless there is a very sharp deterioration in global finance markets – which is always possible.

Forecast for National Debt

• Current forecasts for UK debt predict that the UK public sector debt to GDP ratio will peak at 79.9% in 2015/16. However, in the past few years, government forecasts have regularly been revised upwards due to poor growth and disappointing deficit reduction

Debt including financial sector intervention

Potential Problems of National Debt

1. Interest Payments. The cost of paying interest on the government’s debt is very high. In 2011 Debt interest payments will be £48 billion a year (est 3% of GDP). Public sector debt interest payments will be the 4th highest department after social security, health and education. Debt interest payments could rise close to £70bn given the forecast rise in national debt.
2. Higher Taxes / lower spending in the future.
3. Crowding out of private sector investment / spending.
4. The structural deficit will only get worse as an ageing population places greater strain on the UK’s pension liabilities. (demographic time bomb)
5. Potential negative impact on exchange rate (link)
6. Potential of rising interest rates as markets become more reluctant to lend to the UK government.

However, Government Borrowing is not always as bad as people fear.

• Borrowing in a recession helps to offset a rise in private sector saving. Government borrowing helps maintain aggregate demand and prevents a fall in spending.
• In a liquidity trap and zero interest rates, governments can often borrow at very low rates for a long time (e.g. Japan and UK) This is because people want to save and buy government bonds.
• Austerity measures (e.g. cutting spending and raising taxes) can lead to a decrease in economic growth and cause the deficit to remain the same % of GDP.  Austerity measures and the economy | Timing of austerity

Who Owns UK Debt?

The majority of UK debt used to be held by the UK private sector, in particular, UK insurance and pension funds. In recent years, the Bank of England has bought gilts taking its holding to 25% of UK public sector debt.

Overseas investors own about 30% of UK gilts.

More at: who owns UK debt?

Total UK Debt – Government + Private

• Another way to examine UK debt is to look at both government debt and private debt combined.
• Total UK debt includes household sector debt, business sector debt, financial sector debt and government debt. This is over 500% of GDP.Total UK Debt

UK Budget Deficit

The UK budget deficit is the annual borrowing requirement. It is measured by public sector net borrowing.

More on the annual budget deficit

Private sector savings

When considering government borrowing, it is important to place it in context. From 2007 to 2012, we have seen a sharp rise in private sector saving (UK savings ratio). The private sector have been seeking to reduce their debt levels and increase savings (e.g. buying government bonds). This increase in savings led to a sharp fall in private sector spending and investment. The increase in government borrowing is making use of this steep increase in private sector savings and helping to offset the fall in AD. see: Private and public sector borrowing

Government spending

More statistics on UK government spending

Other Countries Debt

See also:

• Should we worry about National Debt?
• The biggest lie in UK politics? – Is the debt issue exaggerated?
• Should the pace of the UK’s deficit reduction be slower?
• How much can a government borrow?
• US National Debt
• Books on Debt at Amazon.co.uk
• Problem of Personal Debt in the UK
• How is National Debt financed?

The post UK National Debt appeared first on Economics Blog.

Firstly, we can look at the statistics for the money supply growth rate in the UK.

Source: Bank of England

This shows strong growth in the broad money supply in the years leading up to the credit crunch. – An annual growth rate of 10%. By 2010, broad money supply growth had become negative. This is a result of the fall in bank lending we saw in the recession, and the corresponding effect on broad money supply growth.

Did money supply growth play a role in the credit boom? The main issue was the rise in bank lending, and the type of unsustainable bank lending. The growth of the broad money supply didn’t give a clear sign of an underlying boom. If you look at the money supply from a historical perspective, it has always been difficult to see an easy link between the money supply and the rest of the economy.

Broad money supply over past 100 years.

source: Bank of England

Money Supply in the credit crunch

This first graph suggests that at the heigh of the credit crunch 2008 to May 2009, the money supply was rising at a fast rate, which you wouldn’t expect. This is true, but it only tells half of the story.

Money supply and velocity of circulation

The money supply is the stock of money in the economy. However, it is also very important to know the velocity of circulation of money. The velocity refers to the amount of times this money changes hands in a year. The velocity of circulation has been in long-run decline because of various changes to financial sector. But, in the credit crunch, the velocity fell sharply.

Velocity of Circulation = GDP at current prices / average value of the money stock

In 2009, we see an increase in the money supply because of quantitative easing (Central Bank creating money and purchasing bonds from  banks). This increased the money supply, but during this period the velocity of circulation fell. Banks weren’t lending the extra money. In a recession, people spend less so money changes hands more infrequently.

Therefore, money supply growth of 15% was misleading to economic activity.

source: B of E quarterly bulletin 2011

Money stock and Velocity of circulation

ONS – sadly discontinued series

M4 excluding OFC

Another issue is which measure of money supply to use. The Bank of England are pushing M4 – excluding intermediate OFC’s (shadow banking)

Other graphs of interest

M0 Notes and Coins

The narrow definition of money supply is notes and coins in circulation.

Related

• M4 money supply growth

The post Money Supply in the credit crunch and recession appeared first on Economics Blog.

The first and most important thing is always to ring up and bank and see if they have any better deals than their standard variable rate. Invariably, the standard variable rate is not the best deal. It took nearly an hour of answering questions, but it was worth re mortgaging.

When I first bought the house in 2005, my mortgage payments were £950 a month. Interest rates were higher (about 5%), and I had a standard 30 year repayment. I didn’t like paying £950 a month, so extended my repayment term to 47 years. That helped reduce the mortgage cost.

In the past two years, I had a fixed rate mortgage rate of 4.5% (£680 a month) I though this was pretty poor given base rates were so low. It was a practical example of how bank lending rates were divorced from the Bank of England base rate. (bank rates vs base rates)

However, this time, I was eligible for a better rate because I have 60% LTV (home is worth £240,000. Outstanding mortgage debt £130,000.) Also, helped by lower inflation and a slight easing of credit conditions, bank lending rates are lower than 2 years ago. The choices I had were:

1. 2 year fixed at 2.18% (plus £999 charge) – my monthly payments would be around £492
2. 5 year fixed at 2.88% (plus £999 charge) – monthly payments around £530
3. 10 year fixed at 4.99% (plus £1,100 charge – monthly payments around £702
4. Tracker of – Bank of England base rate + (2.5%) = 3% monthly payments around £500

Barclays fixed rate mortgages (link)

I snapped up the 5 year fixed rate. My logic is that the Bank of England base rate is likely to stay at zero for the next one or two years. But, after that, there is a reasonable possibility, we will exit the liquidity trap and Bank of England base rates could return to 5%. If that happens, a tracker mortgage would become very expensive. If base rates rose to 5%, I would be facing a monthly mortgage bill of 8% – £961.

Because of this possibility, I’d rather get a 5 year fixed than 2 year fixed.

It is possible we could replicate Japan’s prolonged decade of stagnation and ultra low interest rates. In this case, a 2 year fixed would be the best, because mortgage deals will still be very cheap in two years time. However, on balance, I think the likelihood of that occurring is receding, and given a five year fixed is not much more expensive than a two year fixed, I’d prefer the security of fixed payments for the next five years.

Maybe I should have taken 10 year fixed whilst I can. In 10 years time, interest rates could conceivable 5-10%. But, I’m quite attracted to 5 years of very low monthly payments, and who knows about next year, let alone six years hence.

Economics of mortgage payments

As a homeowner, it shows the importance of the base rates to disposable income. If I chose a tracker and the bank of England base rate increased, that’s a substantial fall in disposable income.

Low interest rates will definitely help to increase my spending over the next five years.

There is strong time delay between interest rates and consumer spending. The past two years, I’ve been on a fixed rate of 4.5%. Only now with the credit crunch receding am I am going to be benefiting from low base rates. Because I have a five year fixed rate, future changes in the interest rate won’t really affect my disposable income.

Personal preferences

Generally, I like to have lower payments now. I was quite happy to extend my mortgage term, even though it means higher overall payments. One important factor is that I expect inflation to reduce the real cost of mortgage payments over time.

In the past 10 years, inflation in the UK has averaged 3.2%. £720 in 2002 would now be worth £991.20 (see also mortgage payments and inflation)

As long as my nominal income increases, it will become easier to pay that £720 fixed rate mortgage back.

Fixed rates are good. I quite like the fact interest payments are fixed for the next five years. It prevents any unpleasant shocks because base rates go up.

Lucky

I feel lucky to be able to buy a house in 2005 (helped by lax mortgage lending criteria (I got a self-certification mortgage) and a loan from the bank of Mum and Dad). I’m also conscious of the issue of wealth inequality. If I was renting a similar house, it would be  paying £1,000 a month, but this would increase with inflation, with no hope of ever paying off. I also feel lucky to be a homeowner in a time of ultra-low interest rates. I’m glad I’m not a saver trying to eke out an income from negative real interest rates.

Another lucky factor is buying a house in Oxford, where there is a shortage of houses. Because demand is higher than supply, prices have risen substantially since 2005 (despite the crash). I also feel rising house prices are at the expense of people who are trying to buy a house now. There’s no way I could buy a house in the current climate in Oxford. They are so expensive compared to incomes

But, then in 2005, I thought I was unlucky not to buy a house in 1995.

Long Term Interest rate predictions

When the Bank of England cut base rates to 0.5% in March 2009, most people expected rates to be increased at the end of the year. I certainly don’t think there were many people expecting interest rates to be 0.5% until 2013. Forecasts of rising interest rates have been frequently delayed and put back.

Source: Bank of England quarter Inflation Report via Telegraph

The post Variable or fixed mortgage rate? appeared first on Economics Blog.

The main causes of the great recession involve:

1. Credit crunch and fall in bank lending.
2. Fall in confidence resulting from the financial instability.
3. Fall in exports from global recession
4. Collapse in housing markets leading to negative wealth effects.
5. Fiscal austerity compounding the initial fall in GDP.
6. In Europe, the single currency created additional problems because of over-valued exchange rates, and high bond yields.

Source: Eurostat

The primary cause of the great recession was the credit bubble of 2001-2007 and the resulting global credit crunch (2007-08). This is a short background to why bad debts in the US housing market had such a big effect on economies in US and Europe.

Causes of credit crunch

1. The period 2000-2007 was a time of strong economic growth, low inflation and falling unemployment. Central Banks appeared to be successful in targeting low inflation and ensuring economic stability. However, underneath the macro-economic stability, there were increasing problems, which only became fully apparent later.
2. Housing bubble. Many countries experienced a rapid growth in house prices. House price rose faster than inflation and faster than incomes. This boom in housing was encouraged by a growth in bank lending and high confidence. Several countries, such as Ireland and Spain also experienced a boom in  house building.
3. Bad loans. In the period leading up to the credit crunch, banks became more aggressive and willing to take risks in lending. Especially in America, banks and mortgage companies loosened their criteria for giving mortgages. Many homeowners were given large mortgages, with limited checks on their ability to repay.
4. Bad loans repacked and resold. These ‘bad’ mortgage loans were sold onto other financial institutions around the world. For example, many UK and European banks bought these mortgage bundles from the US (CDOs) and so were exposed to any potential losses in the US housing market.
5. Housing Bubble Burst. In 2006, the US housing market bubble burst. House prices started to fall, and there was a rise in mortgage defaults. Banks started to realise they had lost significant sums of money through the US mortgage defaults.
6. The scale of bank losses started to increase and it became more difficult for banks to borrow money on money markets. This caused banks to reduce loans and mortgages. Because banks were losing money, it became very difficult to get credit and liquidity. Some banks lost so much, they were running out of money. In several countries, such as UK, Ireland and US, major banks had to be bailed out by the government. But, the realisation banks were short of liquidity harmed consumer and investor confidence. The fall in confidence led to lower spending and investment.

The role of the credit crunch and recession

• In 2008, all major economies experienced a very sharp drop in real GDP. The banking crisis severely curtailed normal bank lending. The result was a fall in investment and consumer spending leading to a sharp drop in real GDP.
• The fall in house prices was another factor leading to recession. In the boom years, rising house prices (and wealth) underpinned higher consumer spending. When house prices dropped, many homeowners faced negative equity. Therefore, they cut back on spending and could no longer rely on re-mortgaging to gain equity withdrawal.
• The global nature of the crisis meant that there was also a drop in world trade. Countries, saw a drop in exports as the global downturn led to lower demand.
• In 2008, there was also a peak in oil prices. This complicated matters because it caused cost-push inflation. This cost-push inflation made Central Banks more reluctant to cut interest rates. Also, higher oil prices reduced discretionary income and led to lower spending. Usually in a recession, oil prices fall. However, because of rising demand in China and India, we saw rising oil prices – even as Europe and the US went into recession. High oil and commodity prices were another factor reducing demand.

Response to the great recession

• Firstly, governments felt obliged to intervene in the banking sector to avoid banks and financial institutions going bust. However, there was some reluctance to bailout those who were blamed for causing the crisis. In 2008, the US decided to allow Lehman Brothers to go bust. This caused a major loss of confidence. After the panic this created, governments realised they couldn’t allow a repeat of this experience. In the UK, some argue the government were slow to bailout the banks. Though the intervention was sufficient to protect the fundamentals of the banking system.
• Cuts in interest rates. Towards the latter half of 2008 and early 2009, Central Banks cut interest rates to record low levels. The UK cut base rates from 5% to 0.5%. Usually, a major cut in interest rates would make borrowing cheaper and encourage consumption and investment. (e.g. in 1992, when the UK cut interest rates, the economy recovered fairly quickly.)
• Expansionary fiscal policy. The deep recession saw a sharp rise in budget deficits because government tax revenues evaporated. This was particularly damaging for countries who relied on stamp duty and tax from the finance sector. However, in the UK and US, there was a moderate degree of fiscal expansion. The UK introduced a temporary cut in VAT. In the US, there was also a moderate fiscal stimulus.
• It is worth noting that in comparison to the great depression of the 1930s, two things were avoided in the great recession.

• Large number of banks going bankrupt was avoided (In US, over 500 commercial banks went bankrupt)
• There was no major trade war. In the 1930s, a tariff war developed as countries tried to protect domestic industries.

Why did normal policy fail to achieve economic recovery?

1. Firstly, the recession was very deep. Because firms, banks and consumers were highly indebted, they decided they needed to pay down debt. Therefore, this led to a significant fall in spending as they concentrated on paying off debt. In the UK, the saving rate rose from 0% to 7% in a short space of time. This can be referred to as a balance sheet recession.
2. Lower base rates didn’t increase bank lending. Although Central banks cut interest rates, this didn’t translate into higher lending and investment. (an example of a liquidity trap)
   • Commercial banks didn’t pass these interest rate cuts onto their consumers. Especially in the Eurozone periphery bank rates didn’t fall. In the UK, bank rates fell, but less than the cut in base rates. (bank and base rates)
   • Credit remained tight. Although credit was in theory cheap, it was difficult to get any loan. Banks were short of cash so discouraged lending. It became very difficult to get a mortgage, so demand for housing remained low.
3. Eurozone crisis. In Europe, the crisis highlighted the fact that Greek public sector debt was much higher than previously thought. Before 2007, bond yields in the Eurozone had been very low. But, after the credit crisis and realising the true levels of Greek debt, bond yields in Europe rose rapidly. People became nervous about holding Eurozone bonds. The rise in EU bond yields created a new panic. European governments felt the necessity of cutting budget deficits (‘austerity’). This involved cutting government spending and higher taxes. However, in a recession, this fiscal austerity lead to lower aggregate demand and worsened the recession.
4. See more at Euro debt crisis

 Problems specific to the Eurozone

• In the lead up to the recession, Europe experienced a trade imbalance. Germany and some northern countries ran a large current account surplus. (The UK and US also had large current account deficit, suggesting an imbalanced economy)

• Countries in the south, such as Portugal, Spain and Greece ran a very large current account deficit. This meant the south was uncompetitive, leading to lower exports.

• After the crisis, these countries needed to restore competitiveness through internal devaluation – essentially lower wages. This caused lower demand and lower growth.
• No Central Bank. In the UK and US, bond yields fell during the crisis. With their own currency, they have a central Bank willing to intervene and buy bonds if necessary, this avoids any liquidity shortages. But, in the Eurozone, this didn’t occur (at least not until late 2012). Therefore, bond yields rose, and countries felt a need to cut budget deficits quickly. The UK and US only pursued very moderate austerity in 2011/12. But, some countries in Europe, cut government spending very significantly.

• Combined with falling private sector spending, aggregate demand fell sharply.
• Southern Europe is in real depression.
  

  The overall stats for the Eurozone is of a mild recession. But, in southern European, countries like Spain, Greece and Portugal have experienced depression level unemployment and falls in GDP. In Spain, Greece and Portugal, unemployment is close or above 20%. Youth unemployment is even higher.

• Weak monetary policy. The ECB is responsible for the whole Eurozone and is unable to target higher growth in depressed areas. The UK and US adopted quantitative easing, but not Europe.
• Housing markets vulnerable. Countries like Spain and Ireland saw a boom in house building, which as created a large surplus of housing. This has meant the fall in house prices was more sustained than say the UK.

The UK in the great recession

The initial recession hit the UK hard because of our relative reliance on the finance sector. The drop in GDP was longer lasting than in the 1930s.

Despite, cuts in interest rates and large sums of quantitative easing, the UK economy stalled in 2011 and went into a double dip recession (GDP stats may be revised, but it is clear the economy was stagnating at the least).  Some felt that the government’s austerity drive of 2010-12 was a significant factor in causing this double dip recession. Although spending cuts wre relatively mild, there was also an adverse impact on confidence. However, Unemployment rose less than might have been expected (UK unemployment mystery)  Most economists feel, the UK experience would have been worse, had we been a member of the Euro.

• Bond yields would have been higher
• There may have been pressure for much deeper austerity
• We couldn’t have benefited from 20% devaluation in Pound
• Interest rates would have fallen more slowly
• Less scope for quantitative easing and funding for lending scheme.

However, the UK economy is still reliant on exports to Europe and a continued EU recession is a factor in slowing UK growth.

The post The great recession appeared first on Economics Blog.

The last line was:

MPC have done a good job so far. However the real test may come when there is a rise in structural inflation or global instability.

Given the knowledge of the past five years, how should we update this post,?

1. Central Banks should target inflation and growth

In 2007, I wrote The MPC are responsible for setting interest rates and determining UK monetary policy. They seek to keep inflation close to the government’s target of CPI 2% +/-1 %

But, we should start by adding the full remit of the MPC. In their Monetary policy framework, the Bank of England state, their full responsibility is to:

The Bank’s monetary policy objective is to deliver price stability – low inflation – and, subject to that, to support the Government’s economic objectives including those for growth and employment.

By contrast, the ECB seem to give less importance to economic growth, and seem primarily concerned with low inflation.

“The primary objective of the ECB’s monetary policy is to maintain price stability. The ECB aims at inflation rates of below, but close to, 2% over the medium term.”

From: ECB Monetary Policy

A valid criticism of the ECB during the economic crisis has been the fact they have placed too much emphasis on targeting low inflation. For example, the ECB increased interest rates in 2011, even though the European economy was entering a double dip recession. The ECB have been unwilling / unable to consider more unorthodox monetary tools to boost economic growth.

Euro area inflation

From a narrow perspective of keeping inflation close to the target, the ECB have been quite successful. Eurozone inflation is currently 1.7% and is below the target. However, this period has been very disappointing in terms of economic growth. The EU has entered into a double dip recession. If the ECB had given greater importance to economic recovery and willing to tolerate higher short term cost-push inflation, the EU could conceivably have avoided the double dip recession and done more to reduce the record levels of EU unemployment.

• In evaluation, you could argue that even if the ECB had kept interest rates close to zero, that alone may not have been enough to avoid a double dip recession anyway. However, base rates should not be the only tool that Central Banks consider. Also, the fact that the ECB have been so strident in targeting low inflation, does send signals to European business that policy is more likely to be contractionary.

By contrast, the Bank of England has tolerated much higher headline inflation rates.

From the narrow perspective of keeping inflation within target, the Bank of England has frequently missed the target of CPI 2% +/-1. This failure to keep inflation low has also been magnified by the fact that there has been low nominal wage growth. It means that the high inflation rate has led to falling living standards of both those in work, and those on benefits.

However, given the uniquely challenging circumstances of the past five years, it is fair to defend this choice. It made no sense to use interest rates to reduce inflation when the economy was struggling in a prolonged economic stagnation. Firstly this inflation was primarily cost-push. It was due to the effects of devaluation, rising raw material prices and higher taxes. There is also evidence that prices were sticky downwards; the fall in demand didn’t lead to the fall in prices we might have expected.

But, the fact that wage growth was very low, showed there was no underlying demand pull inflation. To religiously keep inflation close to 2%, would have required a potentially very sharp contraction. Given the prolonged recession, you could argue the Bank of England have been too timid in targeting economic recovery. E.g. direct lending to business may have been more successful.

In evaluation, you could argue this might involve the Bank of England extending its original remit, and it would require the government to play a greater role.

2. Limitations of Traditional Monetary Policy

The other lessons of the past five years is the limitations of traditional monetary policy. In normal circumstances a cut in base interest rates from 5% to 0.5% would ensure economic recovery. However, in the great recession, cutting bank base rates has been insufficient.

Firstly, commercial bank rates haven’t fallen to match base rates. This has been a particular problem in the Eurozone with bank rates in Spain and Greece, higher than before the crisis. See bank rates and base rates

In the aftermath of the credit crisis, liquidity shortages have meant the supply of credit has constrained lending, investment and growth. In other words reducing the cost of borrowing is insufficient to boost demand, if the supply of credit isn’t there.

3. Quantitative easing ineffective.

It is still hard to quantify the effect of Quantitative easing. It is largely an untried policy. But, the experience of the UK is disappointing.

Despite creating over £300bn of extra money, quantitative easing failed to translate into higher broad money supply growth. Quantitative easing largely swelled the reserves of commercial banks, but didn’t translate into higher bank lending. However, in evaluation, without quantitative easing, the recession may have been even deeper.

Figures for money supply M4 give a broader understanding of economic activity than headline inflation rates. Though little attention has been given to M4.

4. Role of Lender of last resort

Before the crisis, Central Banks didn’t need to intervene in the Bond market. However, the crisis has shown the importance of Central Bank intervention to avoid panic rises in bond yields – and the subsequent panic to cut budget deficits.

In late 2012, the ECB finally agreed to undertake whatever it takes to save the Euro. This brought down bond yields in the peripheral countries. But, it raises the question, why did they wait two years? If the ECB had been willing to intervene earlier, they could have prevented the rapid rise in bond yields. They could have reduced an unnecessary interest rate burden for governments which made deficit reduction more difficult. Most importantly, without the panic rise in bond yields, Eurozone economies would have faced less pressure to instigate harsh austerity measures which have reduced demand and economic growth. In this regard, the Bank of England showed the benefits of an independent Central Bank. The crisis also showed the inertia that the ECB can have when faced with a crisis.

5. Inflation targeting too narrow

Back in 2007, it was possible to look at headline economic statistics and come to the conclusion everything was fine. Inflation was low, economic growth positive. No sign of an economic boom and bust. However, there was an unsustainable in bank lending, and asset prices. This shows that it is insufficient to look at inflation. Financial instability can undo all the work of monetary policy.

In evaluation, Central Banks couldn’t have prevented the financial bubble and housing bubble through interest rate policy alone. The boom and crisis showed that interest rates are limited for dealing with the much wider range of economic and financial problems. To prevent the financial bubble would have required a wider range of financial instruments and policies.

Conclusion

The past five years have been very challenging for any Central banker. Given deep recession and cost-push inflation, Policy makers have faced a very unwelcome trade off. However, from the crisis, the most important to lessons to learn would be:

• The limitation of inflation targeting.
• The importance of Central Banks considering economic growth and unemployment.
• The insufficiency of using interest rates to control overall macro-economic stability
• The role of the financial sector in influencing macroeconomic stability.
• The importance that a Central Bank has in acting as lender of last resort and willingness to intervene in bond markets, if necessary.

Related

• ECB vs Bank of England
• An evaluation of MPC in controlling inflation?

The post How successful have Central Banks been in managing the economy? appeared first on Economics Blog.

It is worth bearing in mind that statistics don’t tell the full story. Unemployment rates in the 1930s were barely higher than unemployment rates we’ve experienced in the 1980s and 2000s. However, there is a big difference. In the 1930s, unemployment benefit was minimal – to be unemployed left workers at the real risk of absolute poverty. In the current period, unemployment benefits are relatively meagre, but they enable absolute poverty to be avoided. In that sense the depression of the 1930s created more economic poverty than the current recession.

Nevertheless, the UK was able to recover relatively quicker than many other developed economies, why was this?

The 1930s recession was shorter than the great recession of 2008 - see recessions compared.

The UK economy in the 1920s.

In the 1920s, the UK economy struggled with low growth, high unemployment and deflation. This was due to factors such as:

• A decision to return to the gold standard in 1925, at a rate which many believe was 10-14% overvalued. This overvaluation of Sterling reduced demand for exports, leading to lower economic growth. Many heavy industries, such as steel and coal become less competitive in this period.
• Deflation. The overvaluation of Sterling and relatively high real interest rates contributed to periods of falling prices. This deflation increased the burden of debt and reduced spending.
• Tight fiscal policy. In the aftermath of the First World War, UK debt reached up to 180% of GDP. To reduce debt to GDP in a period of deflation was difficult and required high primary budget surpluses. This required strict budgets, but also because of deflation and low GDP growth, it proved very difficult to reduce debt to GDP ratios.
• See more details at: UK economy in the 1930s

Stock market crash and great depression 1929-31

The stock market crash of 1929 precipitated a global recession. The US was particularly badly affected by the stock market crash because of the growth in credit in the years leading up to it. The UK was more insulated because it had experienced no real credit boom in the 1920s. In fact, the UK was already in a prolonged economic stagnation of low growth. Because the UK economy relied heavily on trade, the decline in global demand, hit the UK economy, and with lower exports, the UK economy went into recession. 1931 was particularly damaging, with real GDP falling 5%. See more on Causes of Great Depression

The 1931 Crisis

1931 was a pivotal year for the UK economy. A European financial crisis (failure of German and Austrian banks) threatened to harm the UK’s financial system. More pressingly, the economy was stuck in a deep recession, with unemployment a real problem. The UK’s membership of the gold standard also looked under threat. Many felt the UK was overvalued and so Sterling was under pressure. To keep the value of the Sterling in the gold standard, there was pressure to:

• Reduce budget deficit through fiscal consolidation
• Increase bank rates to attract money into UK and keep the Pound at its target rate in the gold standard.

1931 Budget

In 1931, the government was under great pressure. There was risk of a global financial crisis spilling over into London markets. The Pound was overvalued and there was a fear, the government would be unable to maintain the value of Sterling. The real economy was also in bad shape, with record levels of unemployment and growing social unrest at the extent of the recession. The Treasury put great pressure on the government to pursue fiscal austerity and reduce the budget deficit. (see: Treasury view) It was felt it was essential to balance the budget and restore confidence in the Pound.

In the 1931 budget, the chancellor Lord Snowden and Ramsay MacDonald accepted the necessity of implement budget cuts. Unemployment benefits were cut and public sector wages were also cut. This split the Labour party, and MacDonald formed a coalition of mostly Conservative MPs to pass the budget.

1931 Leaving the Gold Standard

Ironically, the budget cuts failed to protect the pound anyway. One important reason is that real interest rates were already crippling high at over 8%. The Bank of England were reluctant to further increase rates, given the depth of the recession. By September 1931, Britain had left the gold standard and devalued the Pound.

Recovery from 1932

Leaving the gold standard enabled the government to pursue more expansionary monetary policy. The Treasury were able to:

• Cut interest rates
• Target higher inflation. In 1932, the chancellor, Chamberlain, targeted returning to the 1929 price level and ending deflation.
• The cut in interest rates and higher inflation, enabled a rapid drop in real interest rates. Short term real interest rates fell from 9% in 1931 to 0.6% in 1933.
• Devaluation of the Pound. Against the dollar, the Pound was devalued 28% between 1930 and 1932. This devaluation helped UK exports and boost domestic demand, providing an economic stimulus.

This more accommodative monetary policy, enabled an increase in the money supply of 34% between 1932 and 1936. ( This contrasts to the US, were bank failures caused a contraction in the money supply). This increased UK money supply and fall in interest rates created a motivation to increase private sector investment and consumption. For example, the late 1930s saw a significant growth in housing construction (especially around London and the South East). The 1930s were a period of growing suburbia, epitomised by the growth of ‘metroland’. New homes were built in the London countryside, with direct rail links to Central London. For many in the south, living standards rose in the late 1930s.

The higher inflation rate, enabled a small decline in debt to GDP ratios. Something the government had failed to do in the 1920s. The government were using a moderate inflation to help reduce the real value of the debt ratio.

Uneven Recovery

The rates of economic growth from 1934 onwards look relatively impressive. There was also a significant fall in the unemployment rate from 15% in 1932 to 8% in 1936. However, the great depression was only partly averted. Certain regions of the UK were  badly affected, especially in Wales, the north and industrial areas. In certain areas, regional unemployment rates were cripplingly high, with few employment prospects. In the 1930s, the meagre unemployment benefits meant unemployment was a time of real economic hardship. It was this economic hardship which motivated the famous “Jarrow Crusades” of unemployed workers marching to London.

Men on the Jarrow crusade to highlight the unemployment problem

There is also the likelihood, the unemployment figures below, masked the scale of unemployment. Some estimates put unemployment rates higher, reaching a peak of 22%, rather than 15%.

However, compared to other countries, the experience of the UK in the great depression was relatively mild. Helped by being one of the first countries to leave the gold standard, economic growth rates were relatively higher in UK than many other European countries. The UK avoided the social and political upheaval often seen in other countries. Extremist parties made little headway in the UK. If the recession had been deeper, the political situation may have been very different.

In the late 1930s, a gradual re-armament programme also began a belated fiscal stimulus. This provided an addition boost to demand and economic growth. But, it was only the onset of full scale war in 1939, that saw a return to full employment.

Unemployment

Inflation

Interest rates

Real Interest rates are calculated by subtracting nominal bonds from a three year backward looking weighted average of actual inflation rates.

Years of austerity failed to make a dint in national debt as a % of GDP.

Related

• UK in 1930s
• The impact of the great depression on the UK economy
• Causes of the great depression

The post The UK economy in the 1930s appeared first on Economics Blog.

• Higher inflation target
• Low interest rates and negative real interest rates.
• Devaluation

The article is also interesting for another reason, a short insight into the housing market of the 1930s. Like many people in Oxford, I  live in a 1930s semi detached house. It was a golden era of home building. Supply was elastic, few planning regulations, people were not worried about congestion and overcrowding. The mini private sector housing boom was a factor in helping the UK economy recover.

85% of new houses sold for less than £750 (£45,000 in today’s money). Terraced houses in the London area could be bought for £395 in the mid-1930s when average earnings were about £165 per year. Houses were cheap because the supply of land for housing was very elastic which in turn meant that there was no incentive for developers to sit on large land banks. Underpinning the availability of land for house-building was an almost complete absence of land-use planning restrictions which applied to only about 75,000 acres in 1932 – the draconian provisions of the 1947 Town and Country Planning Act were still to come.

Monetary also played an important role, low real interest rates encouraged a rapid growth in mortgages, enabling more people to buy.

One thing is for sure, buying a terraced house in London for £395 in the mid 1930s was a very good investment!

Related

• UK economy in the 1920s
• Comparing different recessions
• The Treasury view

The post When London house prices were £350 in the 1930s appeared first on Economics Blog.

A current account surplus means that the value of exports is greater than the value of imports (of goods and services).

Net exports is a component of Aggregate demand.  (AD) = C+I+G+(X-M).

Therefore a current account surplus means that the net exports is contributing to higher domestic demand. For example, China has had a significant current account surplus over the past few years. This high demand for exports is contributing to the high level of Chinese economic growth.

If the UK has a current account deficit, this represents a net leakage from the economy. Aggregate demand will be lower than if we had a surplus.

Evaluation

It could be the situation that a current account surplus is the result of a recession and low consumer spending. In a recession, we would expect to see a fall in consumer spending; therefore, we will see lower spending on imports. This will cause a current account surplus. In this case, the low aggregate demand is causing a current account surplus.

A current account surplus is not necessarily a good thing. For example, some criticise Germany for pursuing policies, which lead to a very large current account surplus. They argue that this is leading to lower demand in other European countries. Some economists argue, Germany should seek to boost domestic demand; this will lead to higher import spending and benefit other European countries with a large current account deficit and weak domestic demand.

On the positive side, a current account surplus is an indicator that Germany are very competitive, and this will help them to create jobs and economic growth.

Current account surplus and exchange rate

Another factor to consider is the impact of a current account on the exchange rate. In 2006, China was running a large current account surplus. However, in the past few years, the Chinese currency has steadily appreciated. This increase in value has reduced their current account surplus, and limited the growth in Chinese exports and domestic demand.

If the UK moved from a deficit to a surplus, we might expect to see an appreciation in the Pound (this is due to greater demand for Pounds as people buy more UK exports). The appreciation in the currency will tend to reduce demand (assuming relatively elastic demand)

Related

• Importance of current account deficit

The post How does a current account surplus affect demand? appeared first on Economics Blog.

Financialisation of an economy refers to the situation where the finance sector takes a bigger share of GDP and employment. The consequence of financialisation include the possibility that:

• Financial markets have greater influence over firms and the real economy.
• The economy is more dependent on the strength of the finance sector.
• Widening inequality as the finance sector is often able to capture relatively higher salaries and profits.
• Growth in financial instruments has increased the risk of unsustainable debt and lending levels.
• The nature of the finance sector means that if it fails it is has a much wider knock on effect to other industries. If coal mines close, it doesn’t really adversely affect other industries. But, if banks get into difficulties, it has severe adverse effects for every other industry.

Epstein(2001) defines financialisation as:

“the increasing importance of financial markets, financial motives, financial institutions, and financialelites in the operation of the economy and its governing institutions, both at the national and international level” (Financialization and its consequences)

Growth of Financial sectors in developed countries

Between 1970 and 2008, most industrialised countries saw a growth in the importance of the finance industry.  The total share of finance in value added (GDP) to the economy more than doubled in 11 OECD countries. In terms of employment, economies have seen a growth in the share of financial sector employment.

source: Bank of England

UK Finance sector

Source: Bank of England

UK financial sector growth – strong between 1995 and 2008, but experienced a deeper dip in the 2008 recession.

How important is the Finance sector to the UK economy?

The Office of National Statistics (ONS) ‘Blue Book’ reports that the financial sector accounted for 31.9 per cent of Gross Value Added (GVA) to the British economy. (factcheck)

However, the finance sector includes a wide array of sub-sectors like IT and accountancy. If we just look at financial intermediation (banking), it is closer to 8% of gross value added.

However, another way of looking at the importance of the banking sector is the size of bank assets and liabilities. Until the 1970s, Bank assets accounted for roughly 50 per cent of UK GDP. But, after financial deregulation, bank assets,  rose to 300 per cent of GDP by 2000, and to 550 per cent by 2007. This shows an increased importance of bank assets and lending. (Is Finance sector too big? ECB)

Was over-financialisation to blame?

• The growth of particular financial intermediaries and financial activities did create a significant problem. The growth of unsustainable bank liabilities in the early 2000s, left the economy vulnerable to a financial implosion and the debt deflation we are still experiencing. The search for high risk, high yield lending meant many banks became over-exposed to bad debts. When the first mortgage defaults started in 2005/06, this had an increasing effect on the whole financial sector. The resulting credit crunch was definitely one of the key contributing factors in the subsequent great recession.
• The problem of the financial sector was that bank losses and the banks attitude to lending had a very significant cost to non-financial firms. Banking may only account for 8% of value added to the economy, but even now firms across Europe are experiencing high bank rates and difficulty in accessing credit. This credit crunch in the financial sector has harmed business activity. It has highlighted how the wider economy is heavily dependent on the banking sector. (see: bank rates vs base rates)
• Other problems of over-financialisation. This paper suggests there is empirical evidence to suggest that growing financialisation has increase inequality and had adverse effects in terms of output and employment.
• Concern over short-term profit motives. One effect of increased financialisation is that shareholders and hedge funds have increased influence over firms. This has encouraged firms to place greater emphasis on short term profit goals, to pay higher salaries and place less emphasis on long-term sustainable business growth.
• Inequality. The growth of financialisation has co-coincided with a declining share of wages and corporate profit taking an increased share. (corporate profit share of GDP)

Evaluation

• You could argue the growth of the finance sector is a sign of an increasingly developed economy. With greater mechanisation and improved technology, it is inevitable that the service sector increases in importance and the primary / manufacturing sector decline.
• It is not necessarily a bad thing if the finance sector increases as a share of GDP. It could be partly a reflection of higher living standards, which means more people can invest in shares. There is no intrinsic reason why it better to have 20% of the workforce working in a mine than in a bank.
• The biggest problem of greater financialisation is the fact that banks keen to see rapid growth, undertook increased risk taking and increased lending which wasn’t based on sound fundamentals.The finance sector was rewarding high risk, there was a problem of moral hazard, with financial firms able to take the profits, but relying on the state to bailout when they lost money.
• Another problem of this aspect of the finance sector is that it appeared to slip under the radar of monetary authorities. Central Banks have experience of dealing with inflation and setting interest rates. But, the growth of risky lending was much harder to spot, evaluate and deal with.
• There is a real concern that financialisation has increased inequality. In theory, you could have greater financialisation without increased income inequality. There is no reason why a strong finance sector can’t benefit everyone, but at the moment it does seem to be creating greater inequality.
• The problem with the finance sector is that there is no guarantee, that the mistakes of the past 10 years won’t be repeated in the future. Regulation to prevent unsustainable financial bubbles requires a high degree of political will and competence from regulators.
• Rather than blaming ‘over-financialisation’ I would tend to stress the role of the unregulated and irresponsible lending practises of certain banks and financial institutions.
• A strong, well functioning banking sector can play an important role in promoting economic prosperity. Firms need banks and financial markets to finance investment. However, it depends how the banking sector is created. Do banks take a short term view or long term view? Is the bank lending sustainable? Are banks taking too much risk by borrowing on money markets to make temporarily more profitable loans?
• The finance sector is not the only factor behind the European recession. There are other issues related to failures of fiscal policy, failures of the single currency. Also, even countries like Germany which have a different financial model (and banking sector has not increased in terms of value added, where also negatively affected by recession).

…that investors/owners could not squeeze surplus out of other sectors in the economy as they once could.

I’m not sure about this. I wouldn’t say that banks were unable to squeeze surplus out of other sectors. The fundamental problem is that banks were over-exposed. They had too much debt and liabilities they couldn’t finance in the short term. The problem was that businesses who relied on credit suddenly found bank lending closed to them. This caused firms to suffer unnecessary cash flow problems and this led to lower growth.

Related

• What caused economic crisis? (2009)
• Causes of double dip recession
• Financial instability hypothesis

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