Economics Essays

Economic Problems in the US

2009-11-18T09:30:00.000Z

The US is facing many economic problems from unemployment of 10%, to the deepest recession on record. This recession has also aggravated levels of US debt. Usually, recessions solve trade deficits. But, the US has still been left with a hefty trade deficit of approximately $500bn.

1. Trade Deficit

The US trade deficit has recently fallen from a peak of 6.5% of GDP to just under 5% of GDP. However, this decreashttp://www.blogger.com/post-create.g?blogID=8487128531050281473e is largely because of the sharp fall in US GDP and world trade, and may prove temporary. The great recession caused an unprecedented fall in American consumer spending, which led to lower imports. But, despite a fall in the dollar and lower consumer spending, the deficit is still surprisingly large. The US trade deficit widened between August and September

One reason for the persistent deficit is the Chinese government's policy of keeping the Renminbi undervalued. They are doing this by buying dollar assets such as Treasury bills. It is these capital flows which are financing the US current account deficit and preventing the Renminbi appreciating against the dollar. The Chinese purchase of dollar assets such as Treasury bills have also helped fund the US budget deficit, something the US doesn't really mind.

But, the problem is that the large US trade deficit reflects a persistent economic imbalance.

To rectify the deficit will require:
Further depreciation in the dollar to restore competitiveness. This decline in the dollar will reduce American purchasing power abroad.
A period of lower spending and higher saving rates.

There are some who suggest that we should not worry about trade deficits in an ear of free capital flows and floating exchange rates. If the deficit is too large, the dollar should devalue and this should help solve the problem. As long as people are willing to buy dollar securities, the trade deficit will be financed. (see: Should we worry about Trade deficit?)

But, what happens if the world's appetite for buying dollar assets dries up? The dollar could fall sharply to rectify the trade deficit. The worrying thing is that the financial / economic crisis has still not tackled the underlying economic imbalances that exist in the world economy.

Related

Predicting House Prices and Economic Crisis

2009-11-17T10:06:00.000Z

Readers Question: Many experts assert that the assumption of ever increasing property prices is the main factor that has led to the credit crisis. Do you think that the events that led to the crisis would still unfold even if all the lending institutions over the world had predicted falling property prices?

Firstly, I'm not convinced that the boom in house prices was the most important factor that led to the credit crisis. In the 1980s, the UK experienced a similar boom in house prices (prices rose over 30% towards end of 1980s) But, despite the boom and subsequent bust, we didn't experience a credit crunch to the same extent.

I feel, the main reason for the credit crunch is that the rapid rise in US house prices was fuelled by unsuitable mortgages. It was the growth in unprincipled lending that led mortgage companies and banks to be exposed to significant losses. (see: Credit Crunch Explained - for more on causes of credit crunch.)

Mortgage companies were lending vast sums to people who had little if any chance of paying back the mortgage when the introductory term ended.

Of course, rising house prices (and the expectation of future house price rises) was a key factor in encouraging companies to lend to all and sundry. The expectation (or let us say blind faith) house prices would rise for ever encouraged:
- Mortgage firms to lend with little scrutiny of affordability / ability to repay
- The monetary authorities played little attention to the housing bubble. In fact they never referred to it as a bubble until after crisis started.

If House Price falls had been predicted would things Have Been Different?

Yes,

One assumes that if lending institutions, knew house prices were going to fall 20% - 25% from 2006, they would never have lent the mortgages they did. It is true some mortgage salesmen were paid on commission, regardless of suitability. But, if house prices could fall, presumably, the lending institutions would have been stricter in giving mortgage salesmen to lend to anyone who asked for a $200,000 loan.

When mortgage companies / banks expect house prices to fall, they become very strict on mortgage lending. They require large deposits and are much more strict on income multiples. If you expect house prices to fall, a bank is not going to lend 100% mortgages, but will ask for a say a 25% deposit. This would have protected banks from mortgage defaults which was the prime cause of the credit crunch. If banks had predicted house price falls (or even seen it as a realistic possibility), they would (should) have made much better decision in lending and avoided the losses which, through CDOs were compounded around the global financial system)

It is difficult to Predict House Prices.

In 2000, few would have predicted how much house prices would have risen by 2006.
At the start of 2006, not many lending institutions were predicting 20% house price falls.
At the start of 2009, few would have predicted the house price rises we are seeing this year.

But, in the 2000s, there was a collective amnesia (especially from those lending mortgages) forgetting that house prices can fall as much as often rise. Examples of Japan, and previous busts were ignored in a good example of irrational exuberance.

If lending institutions were able to predict house prices, they would never have made so many bad loans, which subsequently defaulted causing bank losses across the world.

I don't think it is a question of being able to predict house prices. But, avoiding bubble hysteria and being more realistic about potential house price falls.

I also feel the credit crunch could have been avoided if there was very good regulation of mortgage markets in the US. If the government had abolished self-certification mortgages, and mortgages several times income, then the raft of bad mortgage lending would have been considerably less.

No Incentive to Earn More

2009-11-16T09:40:00.002Z

A few weeks ago, I wrote a post about - Better off on Benefits.

It reflects a problem common to many Western democracies. - Many tax and welfare policies designed to reduce relative poverty have the unfortunate side effect of giving low income earners no incentive to get a better paid job / work longer hours.

The reason is that when a worker gets a better paid job, they pay more tax and lose means tested benefits. So there net take home pay is often no better than before. If their take home pay remains the same, we say their effective marginal tax rate is 100%

It is actually quite hard to find statistics which consider the impact of welfare benefits and taxes. Maybe the government doesn't want to publicise how the tax and benefits often create zero incentives. I would guess that most people would assume working longer hours / getting higher paid should lead to higher incomes.

This is an interesting graph showing earned income less taxes, plus a variety of benefits. Note, this is for a typical family of three in Virginia. A single adult would, for example, be entitled to less benefits aimed at children.

Source - Mises.org: which also shows implicit marginal tax rates. Via G.Mankiw
Note: Mises is a right wing think tank noted for its scepticism of government intervention; the example chosen may have been to highlight their point. But, the principle of 100% marginal tax rates is often correct and it does have important implications for policy.

If I had lots of spare time (which unfortunately I don't) I would try to create similar graphs for the UK. But, I have to say, it would be a very time consuming job.

The Long Slow Climb Back to Recovery

2009-11-12T07:40:00.005Z

At one stage, it looked as if official unemployment statistics could rise close to 3 million. So yesterday's unemployment figure of 2.641 million suggests the worst may be over. There was a small monthly fall in unemployment. This meant a 3 month rise of just 8,000 - the smallest increase since the recession began. It is encouraging because unemployment is often a lagging indicator - which means that usually unemployment continues to rise even during recovery. A fall in unemployment at this stage is very welcome.

Combined with improving consumer confidence and growing manufacturing output, it gives more credence that last months GDP statistics were wrong and underestimated GDP

In fact many traders and economists are convinced the recession is over and GDP statistics are misplaced

Chris Williamson, the chief economist at Markit, which produced several surveys showing positive economic signs, insisted that the ONS data was wrong. He said: “We think the numbers are wrong. A whole host of indicators other than ours show that the economy grew in the third quarter, powered by a stronger services sector. There is a risk that these figures could lead to disastrous policy mistakes. The ONS has always found measuring the services sector difficult.”

However, as Governor of Bank of England suggests, even a modest recovery is no cause for '"bunting and celebration". Output is still 6% below 2008 peak. Firms and consumers will be engaging in a balance sheet recovery. In other words, we are still trying to repair our past debts hampering spending and investment.

Also, one of the fundamental causes of the recession - the credit crunch - is still hampering business and firms. Banks are still reluctant / unable to lend and are relying on intervention by Bank of England.

Tobin Tax

2009-11-09T10:56:00.002Z

Definition of Tobin Tax

A Tobin tax is the name given to a specific tax placed on currency transactions.
It was proposed by economist, James Tobin, as a way of stabilising currency markets.
The idea is that by increasing the marginal cost of currency transactions it reduces the incentive to speculate on currency movements. In theory, this prevents destabilising swings in currencies.
Tobin initially proposed a tax of 1% on all currency trades. This has subsequently been reduced to lower figures such as 0.25%. One UK proposal suggested a Tobin tax as low as 0.01%

Advantages of a Tobin Tax

By placing a tax on currency trades, it makes currency trading slightly less attractive. By marginally increasing the cost of currency trading there should be a reduction in speculative trading, leading to greater exchange rate stability in floating exchange rate systems.
Raises Revenue. The global trade in currencies has grown at a very rapid rate. In 2007, the global currency market was worth $3,200 billion a day in 2007, or £400,000 billion per annum. Of this, trade in Pound Sterling as £34,000 bn a year.
A tax set at 0.01% on just Sterling trades would raise £2bn a year. A tax on global currency trades could raise significant sums.
Redistribution from Financial Sector to Developing World. The idea of a Tobin Tax is often seen as a good way to redistribute income from developed world to the developing world. The idea has been seized upon by many aid charities and anti-globalisation protesters. Though James Tobin has often stated that the main purpose of the tax is not about raising revenue and redistributing wealth, but its impact on reducing speculation.
After damage created by speculative investments such as derivatives and futures trading. There has been greater support for intervention to reduce speculative buying in financial markets.

The famous investor George Soros has stated, though it would harm him personally, he thinks a variation of the Tobin Tax could be beneficial for the world economy.

Arguments Against Tobin Tax

Difficult to tax all transactions, it may encourage investors to find ways around the tax.
Decline in currency flows may harm functioning of markets and lead to poor liquidity in currency markets.
Tax may be insufficient to prevent speculative flows and currency movements which are driven by economic fundamentals.
A tax may discourage 'hedging' which is a way of insuring against currency movements rather than discouraging speculation.
If it was introduced unilaterally in one country, e.g. UK then it would lead to loss of financial business as firms trade in other currencies / countries
There may be better ways to deal with speculation e.g. placing lump sum insurance schemes on financial firms who invest in speculative markets.

At the G20 Support finance ministers in US and Canada were quick to condemn the tax, proposed by Gordon Brown, on the grounds of 'we are not in business of raising taxes'. But, the arguments against a Tobin tax are weak. Why do we happily accept a VAT Rate of 15% on basic goods yet, feel a tax of 0.01% on currency would be damaging and unfair?

A Tobin tax is more than just a measure to tax 'undeserving financial speculators' It is not going to undermine the world economy as some of the more extravagant claims may suggest. On balance, it is a sensible policy with many benefits - both economic and social.

Prospect of 0% Interest Rates into 2010

2009-11-06T11:13:00.003Z

The current recession is the longest recession since records began in 1955. It is the deepest since the great Depression of the 1930s. The fact it could have been much worse is scant comfort.

The economy is being propped up with low interest rates, tax cuts, a weak pound and quantitative easing.

Amidst the gloom, there are some signs of recovery. Manufacturing output rose sharply in September (after a sharp fall in August) Confidence has improved somewhat. New car sales (helped by government's scrapage scheme) have risen by a third. All this suggests GDP statistics for the last quarter might be wrong, and could be later revised upwards. Yet, few expect a recovery to be anything but anaemic, and combined with a dreadful fiscal position it creates a strong likelihood of low interest rates.

Rising oil prices and a weak pound will push up the headline inflation rate. But, the Bank needs to learn from its mistake of early 2008 - paying too much attention to temporary oil price induced inflation. Apart from these temporary factors, underlying inflationary pressures will remain muted. They will remain muted because unemployment will remain high and there is considerable spare capacity in the economy. Whilst spare capacity exists and inflationary pressures remain muted, the Bank can keep interest rates low.

At the same time, there will need to be some tightening of fiscal policy (higher taxes) (e.g. VAT will go back up to 17.5% - reducing consumer spending).

These tax rises, could reduce spending and derail the recovery. This deflationary impact of higher taxes makes even less chance for interest rate increases in the near future. It is quite feasible that interest rates could remain at 0.5% for the duration of 2010.

As other countries start raising rates, Low UK interest rates could further weaken the Pound. But, I don't think the government / MPC will be concerned about that. A weaker pound will just be another tool in helping the economy to recover. They may not like to admit it, but the monetary authorities seem to have a policy of 'benign neglect' towards Pound Sterling.

During the recovery, any inflationary pressures would justify a tightening of fiscal policy before monetary policy. Government borrowing is uncomfortably high. Government borrowing needs tackling in a way that doesn't create a second downturn. It makes a convincing case for loose monetary policy (0% interest rates, quantitative easing) and tightening of fiscal policy when the economy is able to absorb it.

The other factor is that the economic crisis has arguably changed consumer attitudes, the economy has gone from an economy of borrowers to an economy of savers. Another reason why inflationary pressures will remain muted and interest rates low.

At least some will benefit from the current economic situation. Now, if only I had bought a tracker mortgage in 2007....

Japanese Economy 2010 and Beyond

2009-11-04T08:07:00.002Z

The UK budget deficit is predicted to rise from 40% of GDP last year, to 100% of GDP by 2014.
Japan by comparison already has a budget deficit of 218% this year and a predicted deficit of 246% by 2014.
Japan has a real problem in the unprecedented scale of its fiscal deficit. It also has a real problem with deflation. Japanese consumer prices fell 2.4% in September, the largest on record.
Exports have fallen 31% after the great recession and a rapid appreciation of the Yen.
Demographics are working against Japan. The workforce is contracting due to low population growth and an ageing population. The Japanese economy has stagnated (grown below potential) ever since its 1980s bubble burst.

The economic situation is dire. The immediate policy response should be to end deflation. Japan desperately needs a positive rate of inflation. This will help prevent real debt burden rising. Inflation will reduce the value of the Yen, making exports more competitive.

Combined with a loosening of monetary policy, Japan will be able to start tackling its budget deficit. Yet, the Bank of Japan has already indicated that it will end its limited policy of quantitative easing meaning there are no real policies to deal with the deflationary pressures. It seems Japan doesn't have the political will to deal with the problems it faces; it is almost as if it is waiting for a real crisis. (Perhaps when markets start to worry over extent of Japanese debt)

Why has Huge Budget Deficits failed to boost Growth in Japan?

Increasing government debt, during a period of deflation does not really help. Budget deficits can provide a boost to aggregate demand, if combined with positive money supply growth.
Also, budget deficits need to be a temporary affair, not a permanent two decade fiscal expansion. The deficit also reflects the structural weaknesses of the economy - pension requirements growing in an ageing population.

Lessons for UK and US.

The lessons for the UK and US from Japan are:

Avoid Deflation at all Costs. Don't implement timid policies claiming you are frightened at the prospect of inflation.
Avoid Government debt rising for two decades.
If necessary monetary policy will have to take slack from fiscal tightening, when the time is right.
Avoid having a very strong currency when your economy is in recession and exporters are suffering.
Make sure the economy remains dynamic and productive through incentives to be more efficient.

National Debt in Japan
Japan Saving Ratio
Deflation in Japan
It is Japan we should be worrying about Ambrose Evans-Pritchard in Telegraph

Problems Facing UK Economy in 2010

2009-11-02T09:30:00.002Z

It's been a bad 12 months for the UK economy. 2010, should see some kind of economic recovery. But, few are expecting a rapid rebound. These are some of the problems facing the UK economy, into 2010.

Depth of the Recession.

Typically, the UK economy expands at an average underlying trend rate of about 2.5%. Even zero growth will lead to a growth in spare capacity and unemployment. After 6 consecutive quarters of falling GDP, the output gap is significant. This means output is significantly below potential, firms will be reluctant to hire. There is a danger that the recession will lead to a permanent loss of output and jobs and shrink the UK's productive capacity .

Unemployment.

The Bank has an inflation target of 2%, but it is unemployment which creates the most social / personal misery. So far, the rise in unemployment has been relatively muted, at least, given the scale of recession. However, this slow rise in unemployment means it will be slower to fall. After the 1992 recession, unemployment fell relatively quickly, but after this recession, the fall in unemployment is likely to be slower - more like the experience of the 1980s where unemployment remained close to 3 million for several years. In particular, it is young workers who have been hardest hit. The fear is that prolonged youth unemployment could lead to a return to the unemployment related social unrest, characteristic of the early 1980s.

Budget Deficit.

In the past few years, the UK's public finances have taken a real battering, leading to record peace time deficits. We relied on bubble taxes (property taxes, income tax on bonuses e.t.c) to help fuel inflation beating rises in government spending. Yet, these tax sources have dried up leading to a budget deficit approaching £200bn.

The dilemma is that, although the budget deficit continues to rise towards 100% of GDP, reducing the deficit too early could push the economy back into recession. For example, if the Conservatives were to implement their plans for spending cuts next year, the deflationary effect could well push a fragile economy back into recession.

Problems of Prolonged Borrowing

Economic necessity will make it difficult to tackle the budget deficit. But, this means the budget deficit will continue to grow and this brings future problems. If debt grows too quickly towards 100% of GDP, it may effect the UK's credit rating. This would make it more expensive to borrow and pay the debt interest payments.

In the longer term, there is a also a fear relating to the size of the debt and quantitative easing. Increasing the money supply, rises the prospect of future inflation and a weaker sterling. At the moment, there is little real fear of inflation and a weak pound is helping the economy to recover. But, there is a danger continued high levels of borrowing could weaken pound and could create future inflation.

Trade Deficit / Unbalanced Economy

The UK has been running a current account deficit, more or less since the recession of 1981. The economy has relied on services and the financial sector. We have struggled to remain competitive in the manufacturing / industrial sector leading to a trade deficit. Often the problems of trade deficits / decline in manufacturing are exaggerated, but the UK economy does still feel unbalanced and this is one reason why the UK economy was hit by the recession much more than other countries.

Propensity to Boom and Bust

I have written about the problems of UK housing market in more detail here. Yet, the continued shortage of supply means the UK will be sensitive to future booms and busts. It is hard to believe house prices have risen so much in the middle of a recession - a sign of the fundamental imbalances which exist in the housing market.

Weak Sterling

At the moment, I don't see the weak sterling as an economic problem. The depreciation has helped to limit the fall in economic growth and, over time, will help to rebalance the economy and reduce trade deficit. But, if sterling continues to be weak over the longer term, there could be inflationary risks and a decline in living standards as imports become more expensive.

Demographic Changes - An ageing population and unfunded pension deficits, will make the governments public finances more difficult in the future.

These problems, could equally be applied to the US economy. I think one important issue is to be clear on which problem is the most serious. For example, government borrowing is a definite problem. But, although it is very serious, it is more important to worry about the loss of output and unemployment first.

Related

Asset Purchase Scheme and Money Supply

2009-10-30T08:13:00.003Z

Assets bought by the Bank of England in the Asset Purchase Facility source: B of E

The theory behind quantitative easing is that it should increase - the money supply, bank lending and economic activity.

To simplify the scheme.

The Bank of England creates money electronically. (They just increase their balances.)
They use this created money to purchase assets. (As you can see, so far, this is mostly government gilts - useful for financing government debt, though as the Bank says, this a pure co-incidental side effect...)
Banks and financial institutions are selling their gilts to the Bank of England, therefore, they should have an increase in their money balances. In theory, with greater cash reserves, they should be willing to lend this out to private enterprise helping investment and economic activity.
Also, by buying gilts, the price goes up and the yield (interest rate) goes down. This decline in gilt yields (interest rates) should also help to increase economic activity (more incentive to spend rather than save.

How Effective is It?

It is still difficult to say how effective the scheme is. It will be subject to time delays, and the economy may have been much worse than without it. However, data released by the Bank of England, suggests the UK is still suffering from low growth in the money supply and low economic activity. Whilst other countries like US and Eurozone are escaping recession, the UK may need further quantitative easing to boost its prospects.

An Adjusted Version of M4 Growth

An Adjusted measure of M4 fell 0.9% in September (OFC stands for other financial corporations)
The household sector’s holdings of M4 rose by £3.0 billion in September. The annual growth rate fell to 2.5%.
M4 lending (excluding the effects of securitisations etc) to the household sector rose by £1.6 billion. The annual growth rate fell further, to 2.0%.
source: B of E
M4 is a measure of broad money - It includes the amount of notes and coins in circulation, plus bank and building society deposits.

The Economic Wealth Effect

2009-10-27T12:28:00.000Z

2008, saw a precipitous decline in UK wealth. UK wealth fell to £5.8 trillion at the end of 2008. A decline of £844bn or 13%. The decline in wealth was a combination of a £394bn fall in housing wealth and a £450bn

Although, in 2009, house prices have stabilised and stock markets have showed signs of recovery, the outlook still looks bad with wealth expected to decline a further £251bn in 2010.

Whilst these declines in wealth are dramatic, they should also be placed in context of rapidly rising wealth during the long house price boom since the mid 1990s. Rising house prices contributed to growing wealth inequality between property owners and non-property owners. Wealth is still much higher than in the mid 1990s.

Impact of wealth on Economy.

Economists generally agree that wealth has at least some impact in influencing consumer spending. For example, rising house prices help to boost consumer spending for two reasons.

Householders feel more confident to spend. Saving rates tend to fall because householders view housing equity as a form of saving. It is no coincidence the saving rate has started to rise as house prices have fallen.
Equity withdrawal. Rising house prices give households the opportunity to remortgage their house and spend the extra money. This source of consumer spending was quite significant upto 2007. See: Graph of Housing Equity withdrawal

The impact of stock market wealth is perhaps less noticeable. Short term fluctuations have limited impact in effecting consumer spending. However, a prolonged, sustained fall does affect income from pension funds and investment trusts. When consumers realise the decline in their pension fund, they start to adjust the spending and may increase their own savings to compensate for lower pension funds.

Changes in wealth do not always directly affect consumer spending. Most households do not tie their spending to the value of their house. For most people a rise in house prices doesn't mean much because they can't access it. Although re-mortgaging is popular, it is only taken up by a minority of households.

Yet, the sustained decline in wealth we have seen since the start of 2008, will effect the economy in 2010 and 2011, lower wealth will lead to higher savings and make a recovery slower. The UK economy may have to look for more diverse sources of economic growth than consumer spending. - And that of course may be no bad thing.

Still In Recession

2009-10-26T12:25:00.003Z

After throwing everything at the economy, bar the proverbial kitchen sink, Britain's policy makers will be deeply disappointed to see the UK economy continue to decline, as the recession enters it's sixth consecutive quarter.

Source: ONS

Despite, zero interest rates, quantitative easing, tax cuts and a falling pound, the length of the recession is a reflection of how severe the credit crunch and asset bubble bursting was.

Whilst Germany and France have now recovered from recession, it is worth noting that largely they did avoid a property bubble and were not as dependent on the financial sector as the UK. The US and Spain, both of who shared a property bubble and bust, are also still in recession.

Yet, despite the continued downturn, which means the UK GDP has now declined 6%, and has become smaller than Italy's economy) the outlook is less grim than at the start of the year. Despite continued weak sales, confidence is surprisingly buoyant. Firms are hoping that the worst is over and the weak pound and recovery in the Eurozone will provide a good opportunities for growth over the medium term.

Yet, there are still various worrying signs which may delay the UK's recovery, meaning any recovery will remain anaemic.

Prospect of House price falls. Nationwide recently reported a 6th month of property price rises. This is certainly very helpful for improving consumer wealth and confidence, but the fear is 2010 could see further house price falls as the supply of housing increases.
VAT tax cut will expire at end of year
Prospect of fiscal tightening to deal with record budget deficits.
Continued rise in unemployment
Nervous consumers looking to save not spend.

Baring an unforseen event, this should hopefully prove to be the last quarter of negative economic growth. Yet, it will prove a difficult balancing act to prevent growth remaining very slow in the near future.

How Much Should Bankers Get Paid?

2009-10-20T09:52:00.000+01:00

Readers Question: Should Government Prevent Record Bonuses to Goldman Sachs and Staff of Bailed Out Banks Like RBS?

Goldman Sachs, the US investment bank which employs over 5,o00 people in London, will pay an average bonus of £500,000 this year. Like many of the remaining investment banks, Goldman Sachs have made huge profits this year.

It is claimed RBS is also intending to pay large bonuses to staff, even though RBS was bailed out by the Government. However, RBS claim any bonuses will have to be approved by UK Financial Investments, the company managing the governments 70% stake.

Why Are Banks Paying Such High Salaries?

The Banking sector has become more profitable this year. This is partly due to the decline in competition as banks have been merged or folded. This decline in competition enables them to make higher charges.
Banks claim the wages are a reflection of the workers worth to the firm. They argue, they need to pay high wages / bonuses to the best bankers otherwise they will struggle to get the best workers.

Arguments for Restricting Bankers Pay

The banking sector only survived because of government intervention / bailouts and implicit guarantees. Therefore, the taxpayer has a right to intervene in the industry it saved.
There is a sense of injustice that bankers who caused the crisis are benefiting from huge payouts, whilst many workers are being made unemployed.
Excessive Bonuses were a contributory factor in creating a risky banking environment which led to the credit crisis and subsequent recession. See: Problem with bank bonuses
Bank Pay partly reflects the greater monopoly Power that banks now have

Arguments Against Restricting Bankers Pay

It may seem unfair that bankers get so much pay, but, if firms are willing to pay that amount, then it is an indication that according to free market principles they are worth the wage.
Banker Pay is not the real issue. Arguably the government need to concentrate on regulating lending practises. Cutting Bank bonuses are just a populist measure which does nothing to create a better / more responsible banking sector.
Banks will find a way around. If British banks can't attract the best workers, it will benefit foreign competition which will be able to attract the star investment bankers.
The government / taxpayer will benefit through the collection of income tax at 50% on bank bonuses; these bonuses will help refill the treasury coffers.

Conclusion

The public's anger over bank bonuses is more than just populist anger. Excessive bonuses were a problem behind the credit crisis. The idea banks need to pay £9m to attract star bankers is somewhat thin. Are these the same star bankers who predicted the current crisis and suggested responsible lending practices? I doubt it.

Banks may say it is unfair for the government to intervene in setting their wages. But, is it not unfair the taxpayer had to bailout the irresponsible banking sector? Government intervention can't just be a one way ticket. If you need the taxpayer to bail you out of a crisis, you can hardly blame the taxpayer for wanting to limit excessive pay.

Yet, limiting bank pay is not the real issue. Cutting bank bonuses may make the public feel better, but, it will not, by itself, create a responsible banking sector.

Difficult of bank regulation

Solutions to Unemployment

2009-10-19T09:17:00.003+01:00

A recent report, by Professor Steve Fothergill, suggests that the real level of unemployment is already closer to 3.4 million - much higher than the 1.6m official claimant count statistics suggest (link)

The report suggests the real unemployment level is higher because there are many people unemployed but not entitled to unemployment benefits. (see also: What is true level of unemployment in UK)

In September, the employment rate fell to 72% and the official unemployment rate rose to 8.0%

National Statistics Online

Solutions to Unemployment

1. Demand Side Policies.

Undoubtedly, the main cause of unemployment is the current recession and output gap. With demand falling, firms have spare capacity and so are employing less workers. This is why we have:

0.5% interest rates
expansionary fiscal policy
Quantitative easing.

The problem is that these three demand side policies have been unable to stem the rise in unemployment. This does not mean they have been a complete failure. Without these policies to boost demand, the unemployment rate would be higher. The problem is these policies take time to have an effect.

Employment Subsidies

An employment subsidy could be given to firms who keep on workers part time during the recession. This saves the government the cost of unemployment benefits and prevents workers being idle and losing on the job training. However, the danger of employment subsidies is that they may be misused by firms who see an opportunity to gain extra income. It is also difficult for the government to decide which workers / firms to subsidise.

Cutting Minimum Wages

With stagnant nominal wage growth, the minimum wage is more at risk of causing real wage unemployment. - wages above equilibrium levels. A cut in minimum wages could create extra job opportunities. However, there is no guarantee that cutting wages actually creates jobs. Since the minimum wage was introduced in 1999, successive increases were compatible with a period of falling unemployment. Cutting wages would also reduce overall demand in the economy, creating less demand for workers.

Education and Training of Long Term Unemployed.

Whilst the majority of current unemployment is cyclical, even before the current recession there were pockets of structural unemployment related to a lack of skills. Relevant skills and training programmes would help the long term unemployed get back into work. Few economists would have any objection to the principle of retraining the unemployed. It is essential the skills and education is highly relevant to the needs of the workforce. However, it is a policy often easier to say than actually do. I don't know a time when we haven't talked about the need to improve education and training. But, I do believe that in the UK, too much emphasis is placed on getting 50% of young people a degree when insufficient money is spent on vocational training.

Reclassification of Incapacity Benefits.

The report mentioned above, suggests that many long term unemployed have been given incapacity benefits when there are still jobs they could do. Rather than conveniently putting people on incapacity benefits, more attention could be given to retraining workers for non-manual labour. The potential cost savings of reducing dependence on sickness benefits are significant. Though it will be a difficult balancing act to prevent those really incapable of work being withdrawn from necessary welfare support. Also, this policy will not reduce the official claimant count, but will increase employment rates.

Flexible Labour Markets.

Many economists have suggested high levels of structural unemployment are due to inflexible labour markets. For example, if it is difficult to hire and fire workers this can discourage firms from employing workers in the first place. Arguably this is a much bigger issue in European countries such as France and Spain.

Shorter Working Week.

The theory is that if workers are doing 40 hour weeks, then reducing the week to 30 hours will lead to an increase in the number of workers employed. However, in practise, it is rarely as simple as that. The shorter working week can also act as hindrance to firms.

Geographical Subsidies.

The geographical spread of unemployment is not as bad as in the 1980s, but the north south gap still exists. Of the top 20 areas of unemployment all are above the line from the Wash to the Severn. It is again manufacturing output in the UK's industrial heartlines that has been hardest hit. The fall in manufacturing output 13% is double the fall in GDP 6%. Subsidies / tax breaks may be need to encourage firms to open in relatively more depressed areas.

Weak Pound and Restructuring of Economy.

The weak pound does make UK exports more competitive. It may help manufacturing relative to the consumer sector. In the long term, when the global economy recovers, this boost in exports may help create manufacturing jobs in the north.

Related Posts on Reducing unemployment

Minimum Wage Rates in UK

2009-10-16T11:30:00.002+01:00

The latest National Minimum Wage Rates from 1 October 2009 are:

Workers Aged 16-17 – £3.57
Workers Aged 18-21 – £4.83
Workers Aged 22 and over – £5.80

On one of my posts, there have been many comments debating weather it is fair to pay young workers less than adults. see: National Minimum Wage Rates for Young Workers
Unfortunately, the recession and rising unemployment (forecast to over 3 million) means the minimum wage will come under closer scrutiny as firms struggle to meet wage bills.

A reader asks whether a recession could be solved by cutting the wage of premiership footballers. Rather like banker bonuses, footballers may not deserve such high wage, but, generally such inequality is not the cause of recessions.

Another readers asks - Where will economic growth come from for next year? - Many of the traditional sources of economic growth have been hit. House prices have fallen and in a period of uncertainty, consumers are becoming more attracted to saving than spending. It will be difficult to boost consumer spending.

At least someone is making profits in this recession - Google exceeds expectations and posts $1.6billion profit - saying worst of recession is over. But, the recession has been bad news for Champagne growers

Inflation and Optimal Interest Rates

2009-10-14T09:23:00.002+01:00

CPI inflation fell to 1.1% last month. This is close to the lower end of the government's target for CPI Inflation (1-3%) In many ways, a fall in inflation below the government's target is more dangerous than being above the inflation target.

The prospect of deflation is particularly dangerous given the levels of personal debt in the UK. Deflation increases the real value of debt and could be a powerful disincentive to spend, hindering any recovery. More on inflation vs Deflation

The fall in GDP, low inflation and rise in unemployment all point to spare capacity and a large output gap.

Some commentators are already talking about tightening monetary and fiscal policy. But, given current data, such a move could prove premature and push the economy back into recession.

Output Gap

According to IMF estimates for 2009, the UK output gap is one of the largest in the OECD at over 3% of GDP.

Definition of Output Gap.

The Output gap is the difference between Potential output and actual output.
Output gap = Y - Yf where Y = actual output and Yf = potential output.
A large negative output gap suggests a recession and spare capacity.
A positive output gap suggest actual output is above potential output - Economic growth has exceeded the underlying trend rate leading to inflationary pressure.

Ideal Current Interest Rates

Paul Krugman does a back of the envelope calculation to show according to the Rudebusch version of the Taylor rule:

Fed funds target = 2 + 1.5 x inflation - 2 x excess unemployment

The ideal interest rates would currently be -5.6% in the US. - An indication of the depth of the recession.

Are we taking Money From Future Generations?

2009-10-13T09:12:00.000+01:00

A frequent argument heard at the moment is that idea that the current levels of borrowing mean that we are taking money from future generations. A 15 year old girl recently gained headline for calling on Gordon Brown to apologise for a lost generation (link)

Government borrowing has increased dramatically in the past few years. From just under 30% of GDP to just under 60% of GDP in under 3 years is the sharpest peacetime increase in public sector debt burden.

If government debt as a % of GDP rises, then assuming constant interest rates the debt repayments will rise. Public sector debt is forecast to rise from 30% in 2007 to 80% by 2013. This is a very sharp rise in public sector borrowing. This means current and future taxpayers will have to pay more in interest payments over the next few years. In 2008, debt interest payments account for £31billion (2% of GDP). Debt interest in 2013/14 will exceed £51 billion. But, this figure could be higher if borrowing keeps increasing. To put it in perspective £40bn is equal to roughly 25% of all income tax revenue. £40bn is worth 8p on the basic rate of income tax.

Furthermore, if markets become worried over extent of government debt, and the UK's credit rating is reduced, the interest rate and cost of servicing debt is likely to rise even further as a result.

So future tax rises will be partly going towards paying increased debt interest payments.

Also, it is important to bear in mind.

Public Sector debt has always varied. 30% was a historical low. In the 1970s it was 75%. In the 1950s over 200%.
The massive national debt of the early 1950s hardly led to a lost generation. The 1950s and 1960s were a period of unparalleled prosperity and rising living standards.

The rise in the government deficit was essential to avoid a Great Depression Mark II. If the government hadn't bailed out the banks. If the government hadn't tried to increase spending, the fall in confidence and output could have been disastrous. To allow a repeat of the Great Depression would have been the biggest cost to future generations. The borrowing offset the rise in private sector saving and helped a very weak economy recover. It is economic recovery which is the best hope for improving tax revenues and paying off debt.

Not all the debt, is due to counter cycling factors. There is also the underlying structural deficit related to the increased spending on health, education, social security and pensions. To borrow to pay for current pensions, is effectively to transfer payments from this economic period to future ones.

However, this generation is not unique in running a budget deficit. Historically, we have experienced much worse. This doesn't mean large budget deficits are good. In the medium term, the government needs to tackle the underlying budget deficit. But, the idea of a generation lost because of today's debt, would be a great exaggeration. Just think in 1945, public sector debt was 145%, what did the government do? Savage public spending cuts? No it introduced the national health care service and welfare state. It left office in 1950, with government borrowing over 180% of GDP. Yet, the 50s and 60s witnessed a golden age of economic expansion and rising living standards. So much for the idea of a lost generation....

Changes in Economic Influence / Power

2009-10-12T14:41:00.000+01:00

For many years, emerging economies in the east have been quietly and modestly taking up a bigger share of the world's GDP. For a long time, China has sought to downplay its role, reluctant to flex its large economic muscle. It is still America who dominates global institutions such as the IMF and the World Bank and it is the dollar that currently remains the global reserve currency. But, the recent economic crisis has accelerated the slow and steady shift in economic influence. It is the Anglo Saxon economies that have been hit hardest by the global credit crunch and recession, which is perhaps deserved given the fact the crisis originated there. Amidst unprecedented falls in output and increases in unemployment, there is frequent talk of the US dollar being replaced as the world's reserve currency.

It is not as if, the US is going to disappear from the economic map and sink into obscurity. The US is still the most influential economy in the world, and it will remain one of the most influential be for the foreseeable future, but, it is no longer the undisputed powerhouse it was once. Emerging markets in China, India and Latin America will take a greater share of world GDP and trade. It is only inevitable that these changes will have to lead to changes in the composition of world bodies like the IMF and World Bank. There may be some resistance, but demographics and the seemingly unstoppable economic progress is firmly with the East / south. Whether we like it or not, sooner or later, we could be looking at the Chinese Reminbi and Indian Rupee with the same focus as we currently look at the fortunes of the US dollar and US economy.

Who Wins Who Loses?

The shift in economic power and influence is by no means all a bad thing. The old saying ' When America sneezes the rest of the world catches a cold' may soon become a thing of the past.

How can it be good for the world economy to be so reliant on the whims of the American consumer and American banks? The rise of a new consumer class in the East and Latin America will help create a more diversified world economy. The next time a property bubble and bust occurs in Florida, it may be that it no longer brings the world's financial system to its knees. This is surely no bad thing.

We may have to give up our seats on the IMF (or at least share them with more emerging economies). But, the growth of China and India could have some benefits for our economies in terms of greater trade and a rebalancing of our persistent current account deficits.

The real unknown factor is how the booming Asian economies will effect the global economy in terms of oil shortages, food shortages and the continued impact on global warming. These problems all have the potential to make this credit crisis look limited in impact.

Spending Cuts

2009-10-09T14:47:00.000+01:00

Two years ago, the UK could boast one of the lowest public sector debt to GDP ratios in the OECD. Yet, within a short space of time, the UK has emerged with one of the highest annual budget deficits in the world. The budget deficit is forecast to be a huge £175bn touching 12-13% of GDP next year. This is much higher than the budget deficit of the 1970s, when the UK required a bailout from the IMF.

A significant part of the deficit is due to the recession and attempts to stimulate spending. In particular tax receipts, reliant on a booming property and stock market have collapsed, e.g stamp duty and income tax.

However, in addition to the cyclical factors, the low deficits of 2006, masked an underlying structural deficit which is predicted to worsen as demographic factors increase future pressures on government spending.

Although, fears of government borrowing in a recession are often misplaced, the undeniable fact is that sooner or later, the UK, will need to tackle this worryingly large underlying structural deficit.

Timing will be a fine balancing act. Cut the deficit too soon and too sharply, and we risk plunging the economy back into recession. Cut it too late and we risk unnerving the bond markets with an ever rising need for selling government bonds. It may be that we need to cut the deficit and, at the same time, hope monetary policy can maintain the fragile recovery.

But, with public sector spending reaching nearly 48% of GDP, there is a need to restrain it.

Choosing which sectors to cut will be no easy political matters. It is easy for politicians to say they will cut the unnecessary red tape / bureaucracy costs and leave underlying services. But, has there ever been a time when politicians have not said they will cut bureaucracy costs? Also it is the kind of deficit where trimming the edges and axing a few quangos will do little to make more than a dint on the underlying problem.

Labour say the NHS is a sacred cow and this will not be touched. But, it was health care which was the biggest beneficiary of the now seemingly extravagant spending rises in the boom years. (see: health care spending) 2/5 of this extra spending went to higher pay for doctor and nurses. Anyone fancy imposing a pay freeze on our dedicated nurses and doctors? (and I hope my sister isn't reading) Or does anyone fancy raising the retirement age to 75?

The problem is the deficit will need radical (i.e. politically unpopular choices), and some pressure groups are going to be more than a little upset.

The post on welfare benefits was not very detailed, but, it does touch on the huge figures of over £200bn we will be spending on social security every year. The press love to highlight cases of the government spending tens of thousands of pounds to house a family of 7 asylum seekers e.t.c. But, although it is populist politics, it is still true that we do spend enormous sums on welfare support. It is in areas like Social Security where we may have to find significant cuts. But, again it is a fine line between cutting out the benefit cheats and creating a more unequal society with more living in poverty.

As I've said before, it's not the best time to be the Chancellor of the Exchequer.

The Weak Dollar and Forecasts for 2010

2009-10-08T09:47:00.002+01:00

This year, the Dollar has continued its long term decline which has been in progress since 2000. Since April the dollar / Euro exchange rate has moved from €1 to $1.3 to €1 = $1.48

Why is the Dollar Weak?

1. US Appears Unconcerned about a weak Dollar.

The big crisis facing the US economy is the recession and unemployment approaching 10%. Though the Americans may not wish to admit it, the depreciating dollar will help their economy recover. The Weak dollar will make exports cheaper and imports more expensive and this will increase domestic demand. If the US government is not committed to maintaining strength of Dollar, markets fear it is more likely it will fall.

2. Large Budget Deficit.

The US has a large budget deficit at close to $12 trillion. With financial bailouts and stimulus packages, the deficit is likely to keep growing. Substantial parts of this deficit is owned oversees. This will be easier to pay back if the dollar is weaker.

3. Inflation concerns.

There is also a concern that a large budget deficit will encourage the US authorities to target higher inflation to 'inflate away the debt' At the moment, inflation in US is very low, and spare capacity means inflationary pressures are limited. However, there will be a temptation to continue quantitative easing which could be inflationary.

4. Global Reserve Currency.

Many countries are not happy that the US dollar is the dominant reserve currency. Countries have so many reserves in dollars, but they see these reserves falling in value because of the weak dollar. Therefore, they want to diversify which is why dollar is falling and gold price is going up.

5. Oil Priced in Dollars.

There have been reports arab countries are considering dropping the dollar as the main currency for trading oil. If this occurs, then there will be less need for dollars as countries use other currencies. This would hasten the demise of the Dollar as a global currency. (demise of dollar at Independent)

6. Trade Deficit.

The US has run a persistent current account deficit, which reflects it has more imports than exports. In the boom years, it could attract capital flows to finance this current account deficit. But, in the post credit crunch era, this is more difficult. The depreciation in the dollar is thus necessary to rebalance the long term current account deficit.

7. The Rise of the Euro and China.

For a long time, the US maintained a powerful economic and political hegemony. But, the US economy iss being eclipsed by China and other emerging economies. Also, the Euro, provides a real alternative to the dollar. The ECB seem much more committed to low inflation and stability of the Euro which makes it more attractive.

Does this mean the Dollar will Collapse?

1. The US don't mind a gradual depreciation, but, they wouldn't want to risk alienating investors through creating high inflation and a rapid depreciation. Also, when the economy recovers the outlooks may change.

2. The budget deficit is large in the US, but, it is not the only country to have a ballooning public sector deficit.

3. It is true, China and other countries want to diversify from the dollar. But, it is equally true, China has so many dollar reserves it has a vested interest in avoiding a collapse in the dollar. A collapse in the dollar wouldn't just hurt the US, it would hurt all the countries who have dollar reserves.

People want to diversify from dollar, but if they do it too quickly they could lose a lot.

Overcoming a Liquidity Trap

2009-10-06T14:38:00.000+01:00

see: Liquidity trap explained

Conventional economics suggests a cut in interest rates will boost spending, investment and aggregate demand. Ceteris Paribus, cuts in interest rates

Reduce the cost of borrowing, making loans more attractive
Reduce mortgage interest payments increasing disposable income for householders
Make saving less attractive
Reduce value of currency, increasing export demand.

However, in a liquidity trap, cuts in interest rates will be ineffective. A liquidity trap is a situation where zero / very low interest rates fail to stimulate consumer spending because consumers prefer to save. (e.g. because of low confidence, expectations of falling prices)

A significant cause of a liquidity trap is very low inflation rates or deflation. Deflation makes the real interest rate high and discourages spending.

Policies to Overcome a Liquidity Trap

Quantitative Easing. Quantitative easing is an attempt to increase the money balances of banks and firms. Here the Monetary authorities create money to buy assets such as government bonds. Buying bonds from financial institutions give the banks an increase in their bank balances and lowers the bond yields. In theory, this should encourage banks to increase lending. However, banks may just keep the extra money. On the other hand, if it really increases the money supply, there is a danger of inflation.

Helicopter Drop. Monetarists such as Milton Friedman have advocated bypassing financial intermediaries like banks. They argue banks may not lend their increased money supply but just hoard it and improve their balance sheets. Friedman said money could be given directly to consumers. This policy was termed a 'helicopter drop' to indicate the idea of a central bank dropping money from a helicopter. In practise it might involve something more dignified like sending a cheque in the post. If deflation is a real problem, the Central bank could give money credits which have to be spent by a certain date - to stop people just saving the extra money.

Keynesian Solution to Liquidity Trap

A Keynesian would emphasise the importance of creating positive inflationary expectations. But, would also place emphasis on the role of expansionary fiscal policy in crowding in idle resources. To offset the rise in private sector saving typical of a liquidity trap, they would advocate government borrowing to inject demand into the economy through financing investment projects.

Liquidity trap and fiscal policy

Liquidity Trap Explained

2009-10-05T14:19:00.002+01:00

A liquidity trap occurs when low / zero interest rates fail to stimulate consumer spending and monetary policy becomes ineffective. In this situation, even an increase in the money supply could fail to increase spending because interest rates can't fall further.

A liquidity trap means consumers' preference for liquid assets (cash) is greater than the rate at which the quantity of money is growing. So any attempt by policymakers to get individuals to hold non-liquid assets in the form of consumption by increasing the money supply won't work.

For a long time, the macro-economy was managed by changing interest rates. So it is quite a shock for policy makers to experience a situation where their main policy tool was no longer sufficient. Hence the range of unorthodox monetary and fiscal policies.

Liquidity Trap 2009

Base interest rates were cut to 0.5% in March 2009. For a considerable time, the economy remained in recession. Technically, the economy is now creeping back to positive growth, but, the economy remains sluggish. So 2009, has been a good example of a liquidity trap.

Why do Liquidity Traps Occur?

Expectations of deflation. If there is deflation or people expect deflation (fall in prices) then real interest rates can be quite high even if nominal interest rates are zero. - If prices are falling 2% a year, then keeping cash under your mattress means your money will increase in value. The difficulty is in having a negative nominal interest rates (banks would be paying you to borrow money). There have been attempts to create a negative interest rates (e.g. destroy money in circulation but in practise it is rarely implemented.
Preference for Saving . Liquidity traps occur during periods of recessions and a gloomy economic outlook. Consumers, firms and banks are pessimistic about the future, so they look to increase their precautionary savings and it is difficult to get them to spend. This rise in the savings ratio means spending falls. Also, in recessions banks are much more reluctant to lend. Also, cutting the base rate to 0% may not translate into lower commercial bank lending rates as banks just don't want to lend.
Credit Crunch. Banks lost significant sums of money in buying subprime debt which defaulted. Therefore, they are seeking to improve their balance sheets. They are reluctant to lend so even if firms and consumers want to take advantage of low interest rates, banks won't lend them the money.
Unwillingness to hold bonds. If interest rates are zero, investors will expect interest rates to rise sometime. If interest rates rise, the price of bonds falls (see: inverse relationship between bond yields and bond prices) Therefore, investors would rather keep cash savings than hold bonds.

Liquidity Trap and Fiscal Policy

Tomorrow

Overcoming a liquidity trap

Questions on Bank Policy

2009-09-30T07:59:00.002+01:00

Readers Question from: Gilts bought by the Bank of England

What do you think of the policy - (Gilts being bought by the Bank of England?)

Firstly, it is hard to evaluate the policy as it has not been implemented on such as a scale before. We are charting unknown territory. Also at the moment, the economy is exhibiting unusual behaviour. We are in the middle of a liquidity trap where, for example, a cut in interest rates is not stimulating demand for money. At the moment, the purchase of gilts seems to have had only a limited effect on stimulating bank lending. It appears many banks are just benefiting from selling gilts to the Bank of England. However, although the impact of the policy is so far limited, the Bank will be encouraged at the tentative signs of growth.

However, rather than buying government gilts, the Bank of England may have more impact by buying corporate bonds and increasing bank deposits of firms directly, rather than indirectly through banks.

What do you think of that (inflationary) pressure?

Quantitative easing has so far had little impact on inflationary pressure. Though the increase in the money stock sounds impressive, it has mostly been absorbed by banks in their balance sheets. Tax rises and higher oil prices may push up the CPI in 2010, but, the underlying inflation rate remains low because of the spare capacity and high levels of unemployment. At the moment, it is hard to see any inflationary risk.

And what do you think the Bank can achieve if inflation expectations remain muted?

I think the bank will want inflation expectations to remain fairly muted. Ideally, they will be targetting inflation of 2%. However, they will definitely want to avoid expectations of deflation which could cause a fall in consumer spending as people wait for prices to fall.

If inflation was too low some economists suggest you can either

Pursue negative interest rates (charge banks for holding money or withdraw)
Give money directly to consumers - e.g. a helicopter drop / money gift mentioned by Milton Friedman

US Debt Levels

2009-09-29T10:11:00.000+01:00

US national debt has been rising rapidly. Since September 2007, the National Debt has continued to increase an average of $3.80 billion a day. It now stands at just under $12 trillion. In many respects the steep rise in government borrowing is a cause for major concern. Usually, higher government borrowing leads to:

Crowding out of private sector
Higher interest rates to attract lenders.

However, in this recession, crowding out is not occurring. As we have mentioned before, government borrowing is offsetting private sector borrowing.

This interesting graph from the New York Times looks at overall debt in the US. In 2007, total US debt (i.e. from both public and private sector) was increasing at 10% a year; in 2009, this has fallen to 3%. This is the smallest increase in total debt levels since the Fed began collecting statistics in the 1950s.

The main reason for this slowdown in overall debt accumulation is the fact that private households and firms have been seeking to pay off debts. It reflects the low confidence and change in attitudes to thrift and spending. This wasn't so much a feature of previous recessions. It reflects how much confidence was effected.

It's a similar situation in the UK where national debt is rising rapidly, but, for the first time on record UK personal debt is falling.

Forecasts for Pound Sterling in 2010

2009-09-28T09:16:00.002+01:00

The Pound has been taking a battering in recent years, not helped by a policy of benign neglect by the Bank of England. Despite a 10% appreciation in the first half of 2009, at the end of June 2009(2) the £ERI was around 20% lower than in August 2007.

The Bank of England have suggested that they view the fall of the Pound as necessary - even beneficial. This is for two main reasons:

Underlying Trade Deficit. The UK has been running a persistent current account deficit (importing more good and services than exporting) for the past two decades.(UK Current account deficit) In the past, this trade deficit was financed by attracting capital flows. However, in the post credit crunch economy, these capital flows have fallen. Therefore, the fall in the exchange rate is necessary to rebalance trade. The UK is experiencing a fall in “the long-run sustainable real exchange rate”. The fall in the Pound should help exporters and reduce attractiveness of imports.
Economic Recovery. Part of the Pound Sterling's weakness is due to the perception the financial / economic crisis hit the UK harder than many of our European partners. The UK banking sector is still fragile following the credit crisis and therefore, the Pound is weak to reflect the depth of recession and the likelyhood UK interest rates will stay close to zero for a long time.

In addition to these factors, the other two factors weakening sterling are:

Large Budget deficit. Government borrowing is at record peacetime levels. Very high levels of government borrowing can undermine confidence in a currency see: Why National Debt effects Sterling
Quantitative Easing is being pursued in UK more actively than elsewhere. The extent of money creation is creating a fear of potential future inflation and this undermines Sterling.

These factors suggest that the Pound's current weakness could remain in the foreseeable future and even worsen.

Close to Parity with the Euro
£1 = $1.50

However, some such as Barclays Capital are predicting a rally in Sterling. They suggest sterling could rise against the Euro to Euro 1.25 October 2010. Against the dollar it expects a rise to $1.80.

Why Sterling Could Rise

Weaknesses in the UK economy are matched in US and Eurozone. We are not alone in having ballooning debt and deep recession
The Bank of England seems indifferent to the Pound's fall. But, it is not actively pursuing a weak pound (it also appeared indifferent at the Pound's recovery earlier in the year). It will want to maintain the credibility of UK Monetary policy and could be forced to raise rates should inflationary pressures return.
If the UK does recover, interest rates could rise making sterling deposits more attractive.

Interpreting recent movements in Sterling - pdf available at Bank of England website
Understanding exchange Rates

A Weak Pound and Other links

2009-09-25T08:17:00.002+01:00

Mervyn King indicates he doesn't mind a weak pound as quantitative easing continues. - Pound falls

How The Crisis Spread - Why defaulted subprime debt in US effected Europe and rest of world
GDP and Happiness - Why economists say GDP is limited as a measure of economic welfare
Baltic Dry Index explained - a leading economic indicator suggesting recovery is underway

Interest rate swaps explained - how to make money if you know what's going to happen to interest rates
Financial Conspiracies - some of the crazy conspiracies out there
Questions on public debt
Difference between recession and depression
and Why Spain is looking like a depression