Economics Essays

False Hope Syndrome

2009-07-01T06:02:00.000+01:00

Two Statistics:

Housing Starts 70% lower than during peak of housing boom
Surge in Housing starts as new home builds jumps 17%

Both statistics are true. But, both give completely different interpretations. There is a 17% increase in housing starts, but given low basis, it hardly is much to get excited about.

Also note there was an increase at the start of 2009, only for housing starts to drop back again.

The moral of the story is be wary of statistics. We need to look beyond the headline statistic to understand their context and relative significance.

For example, in the UK, we have seen figures like 15% jump in mortgage lending. But, this is from a very low base. Another way of thinking about the jump is. - Despite zero interest rates, mortgage approvals still close to record lows.

After a deep recession, it is tempting to look for glimmers of hope and build them out of proportion, but, they can be misleading.

Unfortunately, recent revisions to GDP statistics suggested the downturn in the first quarter of this year was worse than expected (often revisions go the other way)

N.B. Understanding the significance, context and importance of statistics is an important skill we try to teach Economics A Level students. Another example is the difference between a fall in prices and a fall in the rate of change.

See also: Misleading economic statistics

Cost of Economic Crisis and Ageing

2009-06-30T10:26:00.006+01:00

A report by the IMF suggests that the fiscal cost of the current recession and economic crisis will be dwarfed by the looming demographic timebomb slowly creeping upon many developed countries.

This forecast is the last thing the government will want to hear, given they are desperately trying to juggle the political and social desire to increase spending, with long term fiscal deficits which require some kind of future spending cuts.

e.g. in US, the net present value of the the current recession to 2050 is about 20% of GDP. But, the net present value of an ageing population is close to 700% of GDP. In Britain the cost of an ageing population is around 300% of GDP

I have talked about the demographic timebomb on previous occasions. If I keep returning to it, the reason is that it is liable to prove the defining economic issue of the next few decades. A few startling statistics.

In 1950, 95 million or 12% of the developed world population was over 60.
In 2010 that has risen to 269 million or 22%.
By 2050 that is forecast to rise to 416 million or 33% of the developed world.
It is almost a tripling of the population over 60. Yet, apart from a few exceptions, retirement ages have increased only by a small amount - if at all.

Source: "World Population Prospects", United Nations 2009

Some countries will be hit more than most:
The Dependency Ratio defined as population over 65 as % of the population aged 20-64.

.	1980	2010	2050
Japan	15%	38%	74%
Italy	23%		74%
US	20%	21%	40%
Britain	27%	29%	46%

Source: "society at a glance" OECD 2009

It is not just a situation related to developed countries, it is also becoming an issue for developing countries like China

This is not to suggest the economic cost of the current recession is a trifling matter, but, what it means is that efforts to reduce the cyclical deficits will prove very difficult as underlying structural deficits play a growing role in shaping government's deficits.

An ageing population should not be a cause of depression. An ageing population is a sign of better living standards, improved health care and longer life expectancy. Improved life expectancy should be welcomed as a major achievement, but, if we expect this increased life expectancy to just equate to increased length of retirement we will let one of the great boons of the modern age become one of the great curses.

Someone will having to be making difficult choices, will the taxpayer be sympathetic?

A slow burning fuse - special report at Economist

Banks Too Big To Fail

2009-06-30T07:03:00.000+01:00

The Governor of the Bank of England recently stated that 'if a bank is too big to fail - it is too big.'

I agree with his sentiments of strengthening bank regulation. But, one question is what size bank would be too big to fail?

In terms of public confidence the size of a bank is not that important. Even if the smallest bank like, for example, the co-operative bank went bust, the impact on confidence would be very damaging. Even a small bank going bankrupt could cause a run on bank deposits and cause nervous savers to keep cash under their bed.

The UK's largest bank like Lloyds TSB / HBOS has too much monopoly power (at 31% of market share). There is a good case for breaking up the merger. But, even if it was broken up, would not the two banks still be too big to fail? So when the Chancellor says 'its more complicated than just the size of the bank' he does have a fair point. After all, Lehman Brothers was by no means the biggest bank, but, its bankruptcy is widely seen as a tipping point in the credit crunch becoming very serious.

Biggest Banks in UK

Moral Hazard and Bank Bailouts

Often economists refer to moral hazard. (see: Moral Hazard and Banks). This is the idea that agents can be influenced to take bad economic decisions. For example, the promise to bailout banks may encourage the banks to take risky decisions in the future. This point is not without merit. The likelyhood of a government bailout could encourage some risky behaviour. However, I think the argument is often overated. Northern Rock didn't pursue its business plan of borrowing on short run money markets because it knew the government would eventually have to bail it out. It pursued its business plan because it really thought this was a short cut to profitability. If the government had said in 2000, - there is absolutely no chance of nationalisation should you you run out of cash, I don't think Northern Rock or any bank would have behaved differently.

Where there is moral hazard is in the bonus culture of many bank executives. As mentioned before pay schemes reward risky - high return investment with no penalty for losing money. This is something banks (if necessary through government regulation) need to address.

Sometimes, free market economists say it's too difficult to regulate banks, banks will just find ways around the regulation. But, this is a lazy approach. Just because bank regulation is not straightforward doesn't mean we shouldn't try. After all, the alternative of hoping for responsible self-regulation has proved to be a total failure.

There are areas where bank regulation can improve. Not least

- Requiring a certain reserve ratio - especially during boom times.
- Limiting the % of funding which comes from short term money markets.
- Regulating bonus culture.

But, note, regulating the size of banks will not solve the problem - alot more is needed

Underlying and Headline Inflation Rates

2009-06-25T08:57:00.000+01:00

This graph shows the headline inflation rate (in US) and the median inflation rate. The Median CPI excludes those items which show the biggest variation either way. This median rate gives a less volatile inflation rate figure. Although this graph is for the US, it would be a similar story for the UK

Importance of Understanding the Underlying Inflation Rate.

The inflation rate plays a key role in influencing decisions on Monetary and Fiscal Policy.

For example, in early 2008, a spike in oil prices caused a rise in inflation. This rise in inflation encouraged Central Banks to keep interest rates high - just as we were entering a recession. In retrospect this was a mistake.

Now, we are faced with prospect of deflation; but, if underlying inflation trends are closer to 2%, then the case for quantitative easing is less strong.

Also, as we argued here, it is a mistake to give too much importance to inflation in the development of Monetary and Fiscal policy. - Is inflation really so bad?

Graph via: G.Mankiw

Health Care Spending in UK

2009-06-24T10:17:00.001+01:00

Or The Insatiable Appetite for Health Care Spending

When the NHS was formed in 1945, the UK was on the verge of bankruptcy. National debt was over 200% of GDP. Yet, the new Labour government went ahead in creating a universal health care which was free at the point of use. In those early days, prescriptions were free and waiting lists low.

In 1945, government spending on health care was £238 million (or £0.238 billion). This was out of a total government spending of £5.9 bn or 3% of total spending. Since 1945, real spending on the NHS has increased much faster than inflation. Health care spending as a % of GDP has also increased.

Health Care Spending In UK (Nominal Terms)

Health Care Spending Real Terms (adjusted for Inflation)

Health Care Spending as a % of GDP

Source: Public spending UK

A few years ago, the government announced large increases in real health care spending. In retrospect this was a spending commitment we can't really afford. Yet, despite this record level of spending. There is still forecasts of a severe spending shortfall of £8-£10 in 2011.

"Having had seven years of plenty it now looks like seven years of famine from 2011 onwards," the NHS Confederation's head of policy, Nigel Edwards, told the BBC. "We are really going to have to think very deeply and carefully about everything we do and subject it to very rigorous scrutiny — and enlist all of our doctors, our front line clinical staff in rethinking the way we do things."

Given the perilous state of UK public finances, there is hardly room for spending increases. From the perspective of public finances, the real spending increases could do with being reversed.

Why is health care spending increasing so much?

More diseases can be treated.
New drugs are often expensive
Increased life expectancy has increased number of old age pensioners who are much more likely to require expensive health care.
Greater expectations of health care.

Solutions to Health Care Shortages

Reduce number of Treatments from non-essential treatments.
Ration Expensive Treatments on a
Allow waiting lists for non-essential treatments to grow again.
Increase taxes to maintain spending.

From an economic perspective the solution of higher taxes is not desirable. Taxes will have to rise to deal with current structural deficit, without increasing spending further.

The problem is that all solutions are politically difficult. It's one thing to say - ration expensive treatments, but when Aunt Dolly could have her life extended by a few years through expensive treatment it is controversial to deny it.

Yet, just because solutions may be unpalatable doesn't make the problem go away. We come back to the fundamental economic problem (discussed in Econ 1 1st Lesson) - which is scarcity of resources and any choice has an opportunity cost.

Related

Whose Fault is It?

2009-06-23T08:02:00.001+01:00

It is tempting to blame the government of the day for the current economic problems. But, economic problems are often cumulative; some caused by government policy, some caused by absence of government policy and some caused by market forces. Also problems may hit the public consciousness at a particular time. But, the root cause of crisis can stem from the past decade or even longer.

Away from political name calling, there is usually no simplistic answer, and it is unfortunate that debate often seeks simplistic solutions.

When did Our Current Problems Start?

Structural Deficits from mid 1990s.

The US achieved a budget surplus during the latter years of the Clinton administration. This was a combination of fiscal restraint and a booming economy. The US went into deficit after the mild recession of 2001 gave an excuse for large fiscal stimulus.

However, the tax cut during the recession was not reversed during the boom years of 2002-06. The opposite occurred and it was accompanied by spending increases (in particular) on health and defence.

There was a similar situation in the UK. a low public sector debt of 29% in 2003, was turned into a structural deficit as the government decided to increase real spending on health care and education significantly.

The decision to run structural deficits during a boom has made the current deficits more damaging and reduced scope for safe fiscal expansion.

But, a structural budget deficit is hardly the cause of the crisis. The real culprits of the current crisis are the banks and mortgage company who grossly miscalculated what constitutes responsible lending.

A key issue in the UK was the financial deregulation of the 80s and 90s. It is no coincidence that former building societies who became banks pursued the most aggressive and unsustainable lending practices.

There was no particular turning point you can put your finger on. It was a cumulative failure amongst bankers, regulators, analysts and government policy. It was the banks who provided a growing driving force for the expansion of financial instruments. Governments generally went along with the vision of the city. Many were sucked into the ideology of the infallibility of markets. It was an easy philosophy to follow, much easier than trying to fight against.

By 2007-08, the structural weakness was embedded deeply into the system. There was little that could prevent the Tsunami of financial / economic crisis. If the government can be blamed for causing the crisis, they deserve at least some credit for not letting it get out of hand. Mistakes were made, not least the dithering over Northern Rock and bankruptcy of Lehman Brothers. But, it could have been alot worse if different policies had been followed. (see: Crisis Averted)

Who is To Blame for Credit Crunch?

Government Borrowing and Output Gap

2009-06-22T17:34:00.000+01:00

The Output Gap is the difference between actual Output and potential Output. With a fall in GDP, the UK has seen a rise in its output gap. This output gap is most easily visible with the rise in unemployment to over 2.25 million.

Public sector net borrowing is the annual amount the government has to borrow from the private sector to meet the shortfall between government spending and tax revenue.

As GDP falls, borrowing rises. Tax receipts fall and spending on unemployment benefits increases. The UK budget was particularly hammered because in the boom we increasingly relied on stamp duty from housing market and income tax from the city. With both the city and the housing market hit hard, the government has seen a dramatic rise in borrowing.

Interestingly in the 1981 recession, government borrowing actually fell. This is because of the different circumstances behind the recession.
In the 1970s, government borrowing rose to 8.1% of GDP in 1975 and 7.2% in 1976 (requiring a bailout from IMF). In 1979, the economy faced high borrowing and inflation of over 20%. The incoming Conservative government pursued strict monetarist policies of tight fiscal and monetary policies to reduce inflation. Taxes were increased. This reduced borrowing but caused a sharp slowdown in GDP and a steep recession. In other words the fall in borrowing caused the recession (though some economists would say it was necessary to reduce inflation. Others said the fiscal tightening went on too long to chase money supply targets which proved misleading. For more info see: 1981 recession)

The 1981 recession was different to the current recession because the motive was to remove inflation from the economy; there was no crisis in the banking system like we see now.

UK national debt

Future Interest Rates in UK

2009-06-19T11:12:00.002+01:00

Between 1999 and October 2008, UK interest rates were remarkably steady. They varied from a peak of 6.0% in 2000 to a temporary low of 3.5% at the end of October 2008 - just before they were dramatically slashed. This represents an era of great stability and coincidences with a period of low inflation and steady growth. Monetary Policy looked pretty unexciting, and rates rarely varied by more than 0.25%. This apparent stability in interest rate policy of cause masked volatility in credit and housing markets.

Graph of UK Interest Rates since 1990

The outlook for future UK interest rates becomes much more difficult to predict. This is because:

The effects of Quantitative Easing are yet to be Understood. Even the Bank of England have said the impact of money creation is hard to know at present time.
On the one hand, many point to the scale of the recession and deflationary pressures. On the other hand others have pointed to the inflationary risk involved in creating money.
The Banking crisis caught many off guard. Further reposessions and a prolonged recession could exacerbate bank losses and cause more economic turmoil.
The UK Housing market plays a key role in influencing the economy. Prices have fallen significantly. The question is how much further will they fall?

You could paint two scenarios

Quick Rise in interest rates to 5 - 6%

The worst of the recession is over. The effect of printing money, zero interest rates, low exchange rate and expansionary fiscal policy will cause an economic recovery and the end of deflationary pressures.
Record levels of Government borrowing could create inflationary pressure.
Global recovery is pushing up commodity prices like oil which will feed into inflation
The impact of increasing money supply combined with a rise in economic activity and bank lending could cause a rapid rise in money supply and inflation.

On the Other Hand You could argue:

Interest Rates Forecast to Remain at 0%

Quantitative easing is having limited impact because banks just don't want to lend given the state of their finances.
UK house prices could keep falling another 20% to return house price ratios to long term trends.
The recession is not yet over and unemployment is likely to keep rising which will diminish wage inflation and inflationary pressure.
Japan experienced a long period of zero rates after its asset price bubble bust. Even quantitative easing and record levels of debt in Japan failed to cause inflation

OK, time to stop sitting on the fence. - What do I think?

Well, somewhere in between. But I believe we will have slow economic recovery which will create some inflationary pressure. But, I do think interest rates will rise to 3 or 4%. I think we will avoid the Japanese experience of zero rates. But, we live in uncertain times and there is an element of wait and see and then revise your forecasts.

Commercial Interest Rates in UK

2009-06-18T08:42:00.000+01:00

Since the Credit crunch, banks have had an excellent excuse to increase their profit margins as they desperately try to claw back their losses from bad investments in subprime CDOs e.t.c

Firstly, the commercial interest rates have remained much higher than the Bank of England Base Rate. One issue is that if the Bank of England raise interest rates consumers may not see such a large increase on their commercial mortgage.

Commercial Rates and Bank of England Rates

Source of data B of E

Gap Between Bank Saving Rates and Bank Lending Rates

The gap between mortgage rates and saving rates peaked in December 2008 with a gap of 4.48%. There has been a little improvement during 2009.

This increased gap basically makes banking more profitable.
Another issue is that the merger between Lloyds TSB and HBOS has created more monopoly power in the banking sector. This week the big two banks both announced an increase in their fixed rate mortgages

Mortgage Rate = Monthly interest rate of UK resident banks (excl. Central Bank) and building societies' sterling standard variable rate mortgage to households (in percent)
Saving Rate = Monthly interest rate of UK resident banks (excl. Central Bank) and building societies' sterling time deposits households

Falling House Prices

2009-06-17T10:23:00.000+01:00

Evidence from the US suggests that the US rice fall have reduced house prices close to or lower than pre-boom levels.

Looking at the ratio of house price to incomes and the ratio of house prices to rent the gains of the boom have been wiped out.

Note: These figures are upto the end of 2008, but, house prices are still falling in 2009 and could keep falling into 2010
The important thing is that the Housing Market can by its nature be Volatile. In other words booms in prices are too big; but, house price falls can be overdone too. This is because of the momentum effect in driving house prices higher and then driving house prices lower.

Ratio of House prices to Incomes in US

source of graphs: Calculated Risk

Ratio of House Prices to Rent

This has potentially important consequences for the UK. In recent months, evidence suggests house price falls have begun to stabilise. But, although house prices have fallen significantly from their peak in mid 2007, the ratio of house price to earnings is still relatively high.

The current ratio of house price to incomes is about 4.0. (down from over 5.1) But, less than the lows of 2.5 we saw at the end of the last bust in 1993 (source: Ratio of House price to Incomes)

Why Have US House prices Fallen so Much?

1. Extent of the recession. The recession has been much more severe than previous recessions making demand for houses fall

2. Extent of the Banking crisis. This has severely limited bank lending which is essential for feeding the mortgage market.

3. Negative Momentum Effect. When house prices are falling, it creates a negative momentum effect causing prices to keep falling. (it's a very different market to stocks and shares where it's easy to buy when you think there are bargains.

When house prices are falling, sentiment towards buying remains negative giving people incentives to 'wait and see'. T

Differences Between UK and US Housing Markets

In some respects the UK is different to the US experience. In our house price boom we didn't have a boom in the building of new houses. In the US, not only are people not buying but there is a large stock of unsold houses putting more downward pressure on prices.

In the UK, people may not be buying but there is not this excess capacity that pushes prices down so much.

Also, whilst the recession has been very deep. Interest rates are also at record lows. For those who can get a variable mortgage, buying a house looks more attractive than renting.

If the house price fall did come to a halt, then house prices would still be relatively expensive and out of the reach of first time buyers.. With this ratio of house prices it would be hard to see another boom. We could see a few years of stagnant house prices (which in itself would be no bad thing) However, if we were to repeat the experience of early 1990s when Real house prices (adjusted for inflation) fell much further or if we were to follow US house prices, we could be looking at another 12-18 months of house price falls.

If house prices look cheap now, there may be even better bargains in 2010.

Principles of Borrowing

2009-06-16T09:31:00.000+01:00

Many worry about a large rise in Government borrowing during a recession. There are still analysts who will say it is irresponsible for government borrowing to rise sharply in a recession. However, to look at government borrowing is to examine only part of the equation. It is important to look at overall borrowing and saving.

The important principle of government borrowing in a recession is that it offsets the fall in private sector borrowing. The government borrows to offset the fall in private sector borrowing and spending.

During a recession, consumers become risk averse; rather than take out loans they seek to pay back loans. For example, this year, more mortgage debt has been paid back than taken out. This fall in private sector borrowing (and corresponding rise in private sector saving) can be very sharp causing a potentially dramatic fall in aggregate demand and economic output. If the government maintained the same fiscal position, there would be a sharp fall in output.

This graph shows the inverse relationship between private borrowing and government borrowing in the US.

source: Brad Setser

Also the fact that private saving rises means there is greater appetite for buying government debt and therefore 'crowding out' and higher interest rates are unlikely to occur.

The difficulty is when the economy recovers and private borrowing starts to rise again. As the economy recovers the government need to reduce borrowing. If government borrowing remains very high when private borrowing is also high, - that is when we will get difficulties of financing the deficit / crowing out e.t.c.

Government Borrowing in a recession is a necessity. The larger the fall in private borrowing the larger the rise in government borrowing needs to be. (Rules like the EU growth and stability pact become a nonsense in a recession like this)

The difficulties will come in 2010, 2011 if the economy recovers and the government is unable to reduce its borrowing. To increase government borrowing is politically much easier than to reduce borrowing. But reducing borrowing (when circumstances dictate) is just as important as the borrowing.

UK National Debt

Who Does the Government borrow from?

2009-06-15T09:41:00.000+01:00

Often people ask me how does government borrow money and who does it borrow from?

Or How to Borrow £220,000,000,000 in a year and keep smiling...

The Bank of England used to be responsible for selling UK government debt. But, now that responsibility is undertaken by the Debt Management Office DMO (part of the UK Treasury)

Given the eye watering figures involved this year, (the DMO will need to raise around £220bn) their job has been made more interesting to say the least... Nearly every week the government is having a gilt auction, where they sell gilts either directly or indirectly to intermediaries who sell on the government's behalf.

The Debt Management Office sell a range of financial securities which are basically loans or I O Us. These bonds have a fixed interest payment. e.g. a £1,000 bond may have an interest payment of £50, giving an interest rate of 5%.

The most common type of debt is a long dated gilt. These have a maturity of say 30 years. They are often bought by pension funds and investment trusts looking for a guaranteed return over a long time. These pension funds are typically UK based funds, but, also include foreign buyers.

Increasingly popular are index linked bonds, this means the interest payment is fixed to the rate of inflation to ensure the real value is maintained.

Because the DMO has to sell so many bonds, they are keen to attract foreign buyers. Foreign buyers are often more attracted by short term gilts which reach maturity in a short time - 3 months, 1 year e.t.c.

A Rating Downgrade would make it more difficult to sell government debt - especially to oversees investors. A rating downgrade or genuine concerns over the UK's ability to repay would lead to investors requiring higher interest payments to compensate for risk.

After a failed gilt auction in March, recent gilt auctions have been oversubscribed - this will come as a relief for UK treasury, but, there is still a long way to go and the Treasury will be hoping demand for UK government debt will remain strong.

At the moment certain factors make the job of the Debt management office easier in selling debt.

Low interest rates, mean the interest rate on government bonds is relatively low. This means the cost of servicing debt is relatively low. If interest rates rose, the cost of servicing national debt could in itself increase the borrowing requirement.
Recession makes commercial bonds unattractive, therefore, investors are keener to go for the perceived security of government bonds.
The Bank's policy of quantitative easing - buying a range of bonds, increases demand for government bonds and this increased demand makes it more attractive to buy bonds in an auction.
The UK's fiscal position, although bad, is comparatively not as bad as many competitors, therefore there is still foreign demand for government bonds - despite threats of rating downgrades.

What Could make selling debt more difficult in Future?

If the economy didn't recover leading to a worse fiscal position than expected.
More bank losses which government need to absorb.
An end in quantiative easing would reduce demand for bonds
Rising interest rates would make it more expensive to buy.
Threat of inflation and devaluation of pound would make foreign investors want to leave UK

Efficient Markets and Hopes of Recovery

2009-06-13T09:51:00.000+01:00

Tentative signs of economic recovery. and Oil prices resumes their rollercoaster ride.
Warning over getting carried away by recovery as unemployment rises
Efficient Market Hypothesis - The idea that markets will correctly predict stock prices and avoid irrational decision making. Needless to say the great recession has punched another hole in this theory. Yet, there are still some who try to maintain markets will rationally and correctly price stocks. See also Psychology of bubbles
How Will sustained government borrowing impact on Economic Growth? - An interesting question. Note sustained government borrowing is different from cycling borrowing in a recession. It seems this is an issue most developed countries will have to face in the 'hangover' of the great depression.
A British Bounce ? - (P.Krugman blog) There are signs that the bold economic policies has enabled the UK recovery to be better than our EU counterparts.

Causes of Debt Crisis

2009-06-11T09:34:00.001+01:00

Causes of Sovereign Debt Crisis Include:

1. Government Borrowing.

High government borrowing often leads to selling bonds to oversees investors. (frequently foreign investors make bad judgements and buy debt from countries who later default.)

2. Bank Loans in foreign currency

If domestic banks take on foreign debts they become liable to repay them in foreign currency. For example, in Iceland, between 2001 and 2008 the three major banks hold foreign debt in excess of €50 billion, or about €160,000 per Icelandic resident, compared with Iceland's gross domestic product of €8.5 billion

3. Bad Debts in Banking system

If you hold this volume of foreign debts and the debtors start to default you lose substantial sums.

Solutions to Sovereign Debt Crisis.

Reduce Budget deficit.

With a sovereign debt crisis, the government will probably be unable to sell government bonds to foreign investors. For example, in June 2009, Latvia failed to sell a single bond at a government auction Reducing the budget deficit will mean the government need to sell less bonds.

However, draconian spending cuts could cause a deep recession. e.g. in 2009, the UK has a forecast budget deficit of 12% of GDP. To reduce this deficit would require a huge tax rise and spending cuts.

Devaluation

A devaluation in the currency means it is easier to pay foreign debts.

The problem is that a sharp devaluation means foreign investors will want to flee the country as they will lose money. Also the devaluation will cause inflation and economic instability.

IMF Loans

Loans from the IMF or body like the EU, can enable the country to meet current debt obligations. This can provide a short term breathing space and help restore confidence.

However, it doesn't address the underlying structural problems.

It can inflate away the debt.

Printing Money can reduce the nominal value of the debt and make it easier to pay the debt, but, it will cause inflation and devalue the exchange rate.

Other Debt Crisis

Sovereign Debt Crisis Explained

2009-06-10T09:25:00.000+01:00

Sovereign debt is the debt a government owes to people outside the country. (e.g. foreign banks or foreign investment trusts who bought government bonds)

If a private firm defaults on debt you can pursue the debt default through legal means. But, when a foreign country defaults, there is usually no legal recourse of action.

Usually, governments are seen as reliable debtors because their track record shows no debt default. However, certain developing countries have defaulted on debt payments causing

Sovereign Debt

If a country has debts issued in its own currency. e.g. US sells bonds denominated in dollar. If the US ever struggled to finance its debt it could print more money to inflate away the debt. This would create inflation and discourage future investors.

Sovereign Debt in Foreign Currency.

The problem is more severe when a country owes money issued in a foreign currency.For example, Icelandic banks took on many foreign mortgage debts.

Latvia has many bonds issued in Euros. Therefore when the bonds are due for repayment they need to find the foreign currency to pay their debt obligations.

For example, Latvia faces a sovereign debt crisis because according to Fitch Ratings foreign debt maturing in 2009 is equal to 320pc of foreign reserves. (e.g. Latvia holds many euro, Swiss franc, and yen mortgages.) It owes more foreign debt than it has foreign currency.

Is the UK Facing A Sovereign Debt Crisis?

UK government debt has increased sharply (12% of GDP this year). There is little chance of an improvement in public finances in the medium term without imposing painful choices on government spending and deflating the economy.
Quantitative easing could create inflation and devalue the Pound making investors want to leave UK.
S&P rating agency said it was likely to downgrade UK's triple A credit rating.

However,

Comparatively, the UK is not exceptionally bad.
Some countries like Ireland and Spain have already had their credit rating downgraded.
A small downgrade from triple A rating is still a long way off a rating of CCC we see in the likes of Latvia and Ukraine
If investors flee the UK where would they go? - nearly all major OECD economies are facing high levels of public debt, recession and possibility of devaluation. The recession is as bad, if not worse, in other major EU economies.
The recent appreciation in the Pound shows the markets have some relative confidence in UK

The Failure of Economics

2009-06-09T09:41:00.000+01:00

After a crisis, it is instinctive to look for someone to blame. (who is to blame for credit crunch) It is usually more complicated than pointing your finger at a number of people. Also, hindsight is a wonderful thing; anyone can be wise after the event. Yet, since the gravest economic downturn since the Great Depression took many economists by surprise, there has been much soul-searching of the economics professions. In particular are economists placing enough attention to the key issues which actually affect people and society - or do they get sucked into insignificant debates over obtuse mathematical models.

Abstract Mathematical models Within the economics profession, many have criticised the prominence of complex mathematical models built on micro-economic foundations. It is suggested the economics profession rewards mathematical brilliance above a greater practical investigation of empricial data

The anti macroeconomic roar at Freakonomics

Too Many Assumptions. One criticism levelled at the economics profession with regard to the current crisis is the assumption that financial markets needed little investigation. There was a lazy assumption that deregulation of financial markets would provide the optimal allocation of resources based on free market principles. However, the limitations of financial institutions and poor incentives has sunk many economic models. (Crazy compensation)
The current crisis has shown the extent to which turmoil in financial markets can affect the wider economy.

Ideologues. Like all professions economists often get stuck in defending certain ideologies, seeking to find data to support their own ideology rather than having a greater flexibility to understand when the model gains greater limitations.

e.g. see: A dark age of Macro economics by Paul Krugman

Related

The failure of Economists by by David Colander, Hans Föllmer, Armin Haas, Michael Goldberg, Katarina Juselius, Alan Kirman, and Thomas Lux:

"We believe that economics has been trapped in a sub-optimal equilibrium in which much of its research efforts are not directed towards the most prevalent needs of society. Paradoxically self-reinforcing feedback effects within the profession may have led to the dominance of a paradigm that has no solid methodological basis and whose empirical performance is, to say the least, modest... We believe that the failure to even envisage the current problems of the worldwide financial system and the inability of standard macro and finance models to provide any insight into ongoing events make a strong case for a major reorientation in these areas and a reconsideration of their basic premises...."

It should be remembered economists don't run the economy. They don't even necessarily make the decisions which influence the economy. The failure of economists is partly due to the difficulty of keeping upto date with a very fast changing financial system. But, there is still huge room for improvement

Difficulty of Bank Regulation

2009-06-08T09:27:00.001+01:00

Amdist the furore over MPs expenses another issue to slip from the public eye is the near banking collapse of a few months ago.

Just to recap:

Banks engaged in very risky forms of lending which ended up leading to large losses. The bad debts meant banks were short of finance and so interbank lending dried up.
Risky bank lending fuelled asset price bubbles in many housing markets, But, the subsequent shortage of lending then hit the housing market and wider economy leading to the deepest recession since the 1930s.
Amongst many mistakes, the Banks badly misjudged risk. Sub prime lending was often rebundled into prime lending and this hid the dangers inherent in the bank lending. Bank Executives / mortgage companies misled if not actively lied about the state of their finances.
Unfortunately, many banks had reduced their liquidity ratio to increase profitability and relied on short term funding. When this short term funding dried up they either went bankrupt (like Lehman Brothers) or relied on massive government bailouts to pull them through.

Some will also say the regulators failed to prevent the banks engaging in irresponsible lending. But, if banks can't lend responsibly what is their purpose?

Since then not a huge amount has changed. At the moment, banks are constrained by economic circumstances and have voluntarily changed their lending criteria, but, when the crisis abates what is to stop a repeat of the previous few years?

Issues which need to be addressed:

The culture of bonuses and reward for risky behaviour. In this post the problem of bank bonuses we saw how bank employees could gain from taking risky options without having to face the cost of losing risky decisions.
Interesting Post - Crazy compensation and the Crisis at Wall Street Journal - which has more on the systemic risk that is encouraged by the set up of many investment funds
Moderating Bank Lending in a boom. In a boom banks get carried away by rising house prices and start lending more. They may say they will be more careful next time. But, can we rely on banks to self-regulate?
Inflation Target Insufficient. The lessons of the past decade is that for macro economic stability targeting inflation is wholly insufficient. Also using just one main variable - Central Bank base rates is also insufficient.

The challenge for macro economics is to:

Understand fully the macro economic impact of bank lending, asset prices on economy.
Develop policy for targeting these other issues like house prices and bank lending.
Set up a workable framework for government owned banks. It is not just free market institutions which can make bad decisions. Governments are just as capable of misunderstanding and bad planning.

One thing which definitely should be borne in mind is the contrast between those financial institutions which remained non-profit making building societies and those building societies who became aggressive, increase market share banks. (Northern Rock, Bradford & Bingley, e.t.c)

Working Life and Pensions

2009-06-03T10:35:00.000+01:00

Even before this recession and remarkably quick deterioration in government finances, there was a compelling argument to increase the retirement age.

The reason for increasing the retirement age was:

Increase in life expectancy. Current retirement ages were set many decades ago, when life expectancy was much lower.
Demographic changes that increase the proportion of retired people. See: Demographic Time Bomb
Increasing retirement age and maintaining reasonable state pension is more attractive than the alternative of increasing taxes or cutting spending.

In the next few decades there is every chance that life expectancy will continue to rise. If in a few decades people are living to 110, 120, how can we afford a retirement age of 65?

The government need to automatically set the retirement age against changes in life expectancy. As life expectancy rises, the retirement age should automatically rise. The current state of government finances only increase the urgency of this.

The government may be emboldened by A Financial Times/Harris survey of 1,126 adults in Britain which found that 60 per cent of respondents would support working beyond the current state pension age in order to receive a bigger pension. (opinions shift to working longer at FT)

Other issues

We may need to change our attitudes to a cut off point moving from working full time to being full time retired. Many there is more scope for older workers working part time.
The government also need to deal with the current means tested pension credit which is a disincentive to save for a private pension

Dependency Ratio

Credit Ratings by Country

2009-06-02T10:15:00.000+01:00

This year has seen a lot of interest in credit ratings as many countries have seen their credit ratings downgraded due to a deteriorating fiscal position.

Firstly credit ratings are an evaluation of how likely a country is to default on government debt (bonds)

A triple A rating is known as prime lending. A triple A rating means there is no risk of the country defaulting on its debt.
An A- means there is a small risk of default.
A B- indicates the investment is highly speculative with a reasonable chance of default
A CCC rating indicates the investment is highly speculative with the country starting to default with little chance of recovery. It is also sometimes referred to as junk status. The Ukraine has currently a CCC rating
A D Rating indicates ' junk' status with the country in default.

Implications of a Lowered Credit Rating

If a country has a credit rating reduced it has certain effects.

It becomes more expensive for government to borrow. If investors see a countries bonds as risky, they will require a higher interest rate to compensate for risk. The greater the risk, the higher the interest rate required. If you are borrowing £175bn a year, even a 1% increase in bond yields can cause a large increase in interest payments on your debt.
More expensive to insure against default. In Feb of 2009 it would have cost $5.95 million in advance and $500,000 a year to insure against $10 million of Ukraine government bonds for 5 years. In other words if you bought $10 million Ukraine bonds you would have to spend about $8.5 million in insuring against default. This reflects the markets anticipation of debt default.
Downward pressure on currency. If investors felt the UK was likely to default, foreigners would be less willing to hold UK bonds and therefore UK currency. This lower demand would cause a depreciation in the currency.
Smaller Current Account Deficit. If less foreigners want to hold US treasuries, it means there are less capital flows into the US, therefore, the US would have to run a smaller current account deficit. This could limit US growth.
Risk of Hyperinflation. If you have junk status and noone wants to buy your debt, there is a risk a government would resort to printing money thereby causing inflation.

Dealing With Downgrade in Credit Rating

The problem is that borrowing increases because of a recession. The solution to a downgrade in credit rating is to reduce governments deficit. This could involve higher tax or lower spending. But, in a recession, this fiscal tightenening could worsen the recession.

The other solution is to monetise the debt. i.e. create money to deal with deficit. However, this can very easily lead to inflation and a depreciation in the currency, making foreigners less willing to hold your currency.

It can be a fine line to walk between running a fiscal deficit to boost growth and not borrowing too much to cause a credit rating downgrade.

Countries who have seen Sovereign Credit Ratings downgraded this year

Ireland, Spain, Greece, Iceland, Latvia (reduced to junk status)

An Economic Crisis Averted?

2009-06-01T09:52:00.004+01:00

Whilst it is still far too early to pat ourselves on the back and look forward to a prolonged economic recovery, the fears of a 'Great Depression mark II' at least seem to have been averted.

Firstly, there were strong parallels between the situation of 2007/08 and 1929. (Causes of Great Depression)

High levels of personal borrowing and debt.
Asset price bubble and bust (in the 20s this was on stock market, in 00s in house prices)
Overconfidence in bank lending leading to rise in bad debts.
Monetary policy too loose in preceding years.
Ponzi schemes like B.Madoff

In the great depression. Output fell by over 30% and unemployment rose to 20%. So far output has fallen by about 4%. This makes it a severe recession, by modern standards - but also a long way from the scale of the great depression.

Recessions and the Great Depression

source: D.Marron

Of course, worse may yet come. But, what are the reasons for averting a more serious recession.

Bank Failure. This is the primary reason for the recession of 1930 turning into a major depression. It was the failure of banks which caused a 30% fall in the money supply, deflation and a loss of consumer confidence. With a few exceptions, governments have pledged to support banks. It may be expensive for tax payer.

Fiscal Deficits. Whilst we are rightly worrying about the size of government borrowing. The fiscal deficits have played a role in stabilising the downturn. If we had pursued the old orthodox model of trying to turn a £175bn deficit into a zero deficit, the fall in consumer spending and investment would have been much steeper.

Quantitative easing. Increasing money supply has reduced risk and magnitude of deflation - a powerful cause of falling output.

In some ways we learnt nothing in allowing a credit bubble and bust. But, in dealing with recessions, we have learnt something from the dark days of the 1930s.

Related

Longest recession since Great Depression
Definition of Depression
Not the Great Depression - at D.Marron

Predictions for Pound Sterling

2009-05-30T20:37:00.000+01:00

(updated June 09) In 2008 and early 2009, the pound was weak because

UK interest rates fell from 5% to 0.5%
UK entered deep recession. The reliance on the finance sector meant the UK was hit hard.
The UK was quick to pursue a policy of quantitative easing (increasing money supply) this has potential to cause inflation and devalue the exchange rate. (money supply and exchange rates)
High levels of government borrowing and the potential inflationary nature of this borrowing - especially if government monetise debt. (why high debt affects exchange rate)
The Pound was overvalued by early 2008 as the UK experienced relatively high interest rates and a long period of growth

However, in recent months, the pound has strengthened. This is not because of a turn around in the UK economy, but a realisation that other EU countries and the US face similar, if not more serious problems.

For example, the German economy has suffered much more than expected because of a strong Euro, and collapsing export demand.

Although the UK economy still faces great uncertainty there are tentative signs of recovery. The Housing market looks more settled than in the depths of the 2008 slump, other areas of the economy are showing tentative signs of recovery. Also the quick fix of low interest rates and quantiative easing have helped boost chances of economic growth and inflation. If inflation does return to the UK, then interest rates will rise making the Pound more attractive.

The outlook for the Pound looks uncertain. A strong low inflationary recovery would help the pound maintain it's strength, but at the moment a strong recovery is very unlikely. I expect any recovery to be quite weak and the high levels of debt will keep foreign investors nervous of investing in the UK.

At the moment, the biggest factor in favour of Pound Sterling is the fact our competitors are facing a similar economic downturn and economic problems.

Related

Run on the Pound - what's the panic? written end of 2008, arguing the Pound's weakness was overdone,
Factors affecting Pound and Euro

US Dollar Forecasts

2009-05-29T08:40:00.001+01:00

The outlook for the dollar looks uncertain. There are certain factors which have caused many to fear a sharp decline in the value of the dollar. Dollar bears point to factors such as:

Rising National Debt

US National debt has risen from 41% of GDP in 2008 to an expected 81% in 2018. Part of this rise in government borrowing reflects the cyclical downturn and the effect on tax receipts. But, the debt also reflects a structural deficit aggravated by an ageing population and health care commitments.

A rise in national debt doesn't have to cause inflation and a depreciation in the Dollar.

(There are many examples of countries with larger national debts who haven't experienced inflation. In recent years one could look at the examples of Japan, Belgium and Canada. These countries have all had national debt of over 100% without causing any significant inflation. Japan's debt has now exceeded 200% of GDP)

However, the US Treasury purchase of dollar bills to finance the deficit is putting downward pressure on the dollar. And many are fearful future rises in government borrowing will just be monetised causing the dollar to devalue. It is this monetisation of the national debt which is putting most downward pressure on the dollar at the moment.

Hyperinflation

There are some analysts who see the increase in money supply and purchase of treasury bills as evidence we will see inflation in the future. This inflation will reduce the value of the dollar. However,

This link is not as clear cut as some suggest - money supply and inflation

Also, current inflation trends in the US are very low. In fact consumer prices are actually falling causing deflation to be a bigger worry at the moment.

Interestingly in the great depression many feared inflation as a reason for the government not to spend more. Yet, the great depression led to a prolonged period of deflation

Interest Rates
The depth of the recession means that, according to the Taylor rule, the ideal US interest rate would be around -5%. This of course is not possible, but, it suggests 0% interest rates could be maintained for a longer time.

On the Positive side there are a few factors which could strengthen the dollar in future months.

Economic recovery. A panel of US economists tentatively suggest the US economy could recover by the end of 2009 and enjoy positive economic growth in 2010. This may lead to interest rates rising from rock bottom and if the US led a global economic recovery, the dollar would likely benefit.

Lower current account deficit. The current recession has gone some way to reduce the US current account deficit and reduce the trade imbalances which made the dollar susceptible to devaluation.

The dollar will always be shaky whilst the US treasury are purchasing Treasury bills to increase the money supply. But, the feared hyperinflation and collapse of the dollar does not look likely at the moment. There is still a reasonable chance the US economy could recover soon with only moderate / normal inflation rates. If this scenario did occur, the dollar could start to look attractive once more.

Economics of Voting

2009-05-27T09:59:00.002+01:00

I rarely venture into politics. I'm too lazy to visit the polling booths so I get a postal vote delivered. The ballot arrived yesterday and the list for the European Parliament reminded me of a scene from Monty Python and the Life of Brian (People's Front of Judea scene). We have the UK Independence Party, The English Democrats, the UK First party, BNP, the No2EU, LibertasEU, Socialist Labour Party (similar to NO2EU party - left wing anti EU), there was even some joker standing for the Roman party e.t.c. There were more, but I can't remember them.

Anyway the economics of voting, is an example of the free rider problem. Why should I spend 10 minutes researching all the different parties and what they stand for when my vote isn't going to make a difference anyway. There is a temptation not to vote but free rider on the efforts of those who do go to the polls.

You could argue voting gives a sense of satisfaction in that you get to choose for the party you think is best.

£1.50 Icecube trays and £175bn annual Government Debt

On another related point it is interesting to see how much media coverage has been dominated by MP's expenses. It seems that government borrowing requirements of £175bn are too vast to comprehend so we'd rather concentrate on MPs who claim duck houses and horse manure on expenses. MP expenses are only a tiny fraction of government spending, but things like horse manure and Icecube trays are easier to relate to than abstract sums.

I recenlty wrote a piece whether MPs should be paid more?

Maybe someone should try to work out the volume of horse manure that would be needed to equal the value of £175bn. That may help people to understand the volume of government borrowing for this year.

What Does 1 Trillion look Like?

UK National debt is heading towards £600bn at the moment

Buying US Treasuries

2009-05-26T11:56:00.003+01:00

Since March the US Federal Reserver has been buying US Treasuries by effectively creating money. The aim of this unorthodox monetary policy is:

Reduce yield (interest rate) on government bonds. The lower interest rates may encourage banks to lend rather than hold US treasuries. Also lower interest rates also help the government reduce the cost of servicing the debt.
Provide Monetary stimulus. By buying US treasury bonds from banks, banks will see an increase in the money supply and in theory will lend to private business and consumers. With a money multiplier this could be quite a large monetary stimulus. Because of the scale of the recession many fear deflation. Therefore increasing the money supply helps to prevent deflation becoming a problem.

Problems of Buying US Treasuries.

Inflation. Creating money to buy US treasuries has the capacity to cause inflation. At the present time the policy is not causing inflation because the falling velocity of circulation means that the increase in the money stock is not currently inflationary. However, in the future, the increased money stock has the capacity to cause significant inflation For more details see: Money Supply US

Foreigners Increasingly Nervous of Holding US debt. 23% of US government debt is held by China and Japan. The US need to raise another $2 tn for this fiscal year. They will be hoping foreigners keep buying US debt. But with the policy of increasing money supply, there is risk of devaluing dollar through inflation. Therefore, buying US debt could see a fall in the value for Chinese and Japanese investors. Recently both China and Japan have become nervous over the scale of US quantitative easing. (see: China warns US)

There is no sign of foreign investors wanting to dump dollar treasuries. It is not in the interest of China and Japanese investors to see a sharp devaluation in the dollar. But, the world's appetite for buying bonds is quickly falling.

see also: quantitative easing Policy in US

Is Inflation Really So Bad?

2009-05-20T10:14:00.000+01:00

Many have been told dire stories of German hyperinflation in the 1920s causing economic upheaval, the rise of Hitler e.t.c. Because of events such as this and in Zimbabwe, there is a strong assumption that inflation is always and everywhere a serious economic problem.

Low inflation (of around 2% ) is indeed the primary economic target of all major economies. Everyone assumes inflation is bad, but, how really damaging is it if inflation rises above the inflation target?

Let us assume that inflation was to rise above 2% closer to 6 or 7% what would be the economic consequences?

Potential Costs of Inflation

Inflation reduces value of savings. High inflation reduces the value of money. Therefore people who keep cash under the bed will see their savings decline. But, who actually keeps money under the bed? If interest rates are higher than inflation then the real value of money will be maintained. Inflation of 7% and interest rates of 9%, is much better than the current situation of inflation 2.9% and interest rates of 0.5%. (which is a negative real interest rate). It is not the inflation rate that determines real value of savings but the real interest rate.

Inflation makes people worse off. Higher prices increase the cost of living. Again the key issue is whether nominal wages keep up with rising price level. As long as real wages remain positive people will not be worse off. All state benefits are index linked meaning that higher inflation will lead to bigger rises in benefits.

International competitiveness. A higher UK inflation rate causes UK goods to become uncompetitive. However, the inflation will also cause a depreciation in the value of pound restoring the competitiveness of exports.

Confusion and Uncertainty It is said high inflation rates create greater uncertainty and confusion leading to lower levels of investment. Alot depends on whether the inflation is anticipated or unanticipated. If inflation is anticipated the impact on uncertainty is much less.

Menu costs. Higher inflation rates mean firms will have to readjust prices more frequently. But, with modern technology it is easier to do.

The Spiral Effect. The big fear of inflation is that a moderate rise in inflation rates causes inflation to inexorably spiral upwards. If we allow inflation to rise a little, before we know it we are facing a real problem with inflation in 3 digits. In practise it is hard to control inflation once it starts to get out of hand. Therefore, its best to keep it low

Conclusion.

Targeting low inflation does make sense. By targeting low inflation we can provide a framework for sustainable and stable economic growth. It helps avoid boom and bust cycles which are very damaging.

However, maybe some Central Banks (in particular the ECB) could loosen up a little and not feel so guilty if inflation slightly overshoots the target. Many years ago, Norman Lamont told us 'unemployment is a price well worth paying for lower inflation' but, maybe this assumption is misplaced and not true. Whilst inflation does have costs, there are potentially much bigger costs of dogmatically targeting low inflation, especially in the current climate.

Also another lesson of this recession is that targeting low inflation is insufficient to maintain macroeconomic stability. The low inflation of the early 2000s seems to have given us a false impression of economic stability.

More on

Costs of inflation