Economic Growth and Vision

In recent weeks, there has been greater lip service paid to the importance of increasing economic growth. In the UK, this is partly in response to the double dip recession. In Europe it is also in response to the continued economic stagnation and popular rejection of austerity.

However, economic growth requires more good intentions.

The Queen's speech was remarkable for its lack of vision and unwillingness to change direction. There were one or two minor suggestions:

• Making it easier to hire and fire workers - could help reduce labour market inflexibility
• Green investment bank
• Splitting banks into retail and investment branches.

There is nothing wrong with these suggestions, but it is like a drop in the ocean. There is no change from mantra of cutting spending now. There is no real commitment to growth.

It is the same in Europe, there has been talk of a 'growth pact' but to the ECB that means a few free market supply side policies - these are actually needed, but is only small part of the equation.

But, Will Socialist France help the Eurozone?

A big issue is whether austerity is self-defeating i.e. can it be that cutting government spending actually increases level of debt to GDP? In the UK austerity has not been self-defeating in that regard. Spending cuts and tax increases have contributed to a gradual reduction in the deficit. However, I believe the long term deficit could be reduced to manegable levels with much less immediate pain. There was no need to push the economy back into a double dip recession.

However, in some European countries, there is evidence that the depth of the recession means that spending cuts are actually self-defeating. Is austerity self-defeating?

What could the government have done to tackle Youth unemployment?

Why does France have a worse Credit Rating than the UK?

When France has a smaller budget deficit...

Source: OECD (2013 forecast)

What Determines Credit rating for a country?

See also: France National debt

Eurozone Deteriorates

source: Office of National Statistics (pdf):

Preliminary statistics last week showed the UK in an official recession. GDP statistics may be slightly revised upwards at a later date. But, at this stage even very low economic growth is not good. It will lead to continued unemployment and persistently lower living standards. By comparison the recovery from the Great Depression was much faster!

However, though things may be bad in the UK, in southern Europe it is a real depression. 

Statistics from Greece, showed retail sales fell by 13.0% in February, in volume terms…” - It's hard to over-emphasis how dramatic this fall of 13% is.

Spain also entered into double dip recession with 0.3% fall in GDP

 

In main blog of week I looked at likelihood of a Eurozone break-up. - Will Eurozone break up?

There are two fundamental problems

1. Imbalances in Eurozone - different competitiveness causing structural current account deficits and lower growth in overvalued south.

 

 

 

2. Austerity isn't Working

 

source: Krugman. Link between changes in austerity measures and GDP

The main policy of Europe has been to try and implement radical budget targets which have caused unsustainable levels of unemployment. Deflationary fiscal policy has been deflationary.

Spanish unemployment hit 24.4% last Friday (April 2012)

This is the big political issue for Europe - what can they do to reduce excessive unemployment?

Will Eurozone break up?

1970s Revisited?

I was watching the very good TV programme about the 1970s. 1973-74 was one of the most turbulent years in British economic history - a boom and bust, rapid inflation, strikes, a 3 day week, petrol rationing - even the first experiments with credit cards, leading to our first credit binge and later bust. There were few things the 1970s didn't have. (Economy of the 1970s)

 

30 years later and there are some unwelcome parallels. Persistent stagflation (inflation + negative growth) Rising oil prices, a much more serious credit binge and consequent debt recovery.

In some ways, things aren't as bad as the 1970s. Inflation of 3.5% is not comparable to the inflation of 20%. The current threat of a petrol blockade is pretty insignificant compared to the actual reality of a three day week. TV off at 10.30pm. Life was very different.

But, at least, the 1970s didn't have such a persistent recession and mass unemployment.

Double Dip Recession

Figures published by ONS today, show that the UK is officially in a double dip recession. Some may wave the figures away saying it is only small fall - and it is just because of a big fall in construction. But, it is remarkable and worrying to see such a prolonged fall in GDP. (Bear in mind the UK's long run trend rate is 2.5%) But, GDP is still lower than in the 2008 peak. That's three years of falling living standards.

More on double dip recession

IMF Bailout

The 1970s, was also a time when the UK needed its only IMF bailout (UK national debt was only around 75% of GDP). These days, the IMF have much bigger challenges than a relatively small debt of 75%. The big concern for the IMF is that even a firewall of £1 trillion does nothing to tackle the underlying problems of the Eurozone.

• Purpose of IMF rescue Fund

Scottish Independence

The discovery of oil in the north Sea during the 1970s, was a factor in contributing to the re-emergence of Scottish nationalism. Economics looks to be the decisive issue in swaying whether people will vote for independence.

• This is a brief look at economic consequences of Scottish independence.

The Economy of the 1970s

See previous decade - 1960s.

The 1970s was not just an era of dayglow trousers, lava lamps and the emergence of punk rock. It was a traumatic economic decade of stagflation, a three day week and the return of unemployment. Yet, despite some headline grabbing crisis - it was also a decade of rising living standards, the growth of credit and rising property prices.

Graph showing combination of high inflation and volatile output.

Barber Boom 1970-73

 The early years of the 1970s, were a period of rapid economic growth.

1. The Bank of England deregulated the mortgage market - meaning High Street Banks could now lend mortgages (not just local building societies). This helped fuel a rise in house prices and consumer wealth.
2. Barber Boom of 1972. In the 1972 budget, the chancellor Anthony Barber made a dash for growth - with large tax cuts against a backdrop of high economic growth.
3. Growth of Credit. It was in the 1970s, we saw the first mass use of credit cards (Access). This helped create a consumer bubble.

Inflation Crisis

By 1973, inflation in the UK was accelerating to over 20%. This was due to:

• Rising wages, partly due to strength of unions
• Inflationary budget of 1972.
• Growth in credit and consumer spending
• Oil price shock of 1973, leading to 70% increase in oil prices.

Trying to Deal With Inflation

Belatedly, the government tried to deal with unemployment, through higher interest rates. Also, the Heath government tried capping wages. This was fuel for industrial unrest, leading to frequent and widespread strikes. In 1973, the miners went on strike and were also joined by sympathetic trades unionists - led by, amongst others, the young and infectiously strident Arthur Scargill. Growing up in Thatcher's Britain, it is hard to remember how powerful trades unions actually were at the time. During Heath's government 9 million working days were lost to strike action - plus more to practises such as 'working to rule'. Flying pickets successfully blocked coal and coke factories, which at the time produced the majority of the nation's power. Suddenly the life source of Britain's energy was being blocked. At the height of the strike, Britain was on a 3 day week, with the Prime Minister, Edward Heath making public appeals to conserve energy.

1974, also saw an unwelcome return of a real recession. This recession was caused by the end of the Barber boom and falling living standards from rising prices. In the post war period, we had booms and busts, but, the bust were relatively mild, with only very minor declines in output. But, in 1974, output fell 3.4% causing a return of high unemployment not seen since the 1930s.


Oil Prices in 1970s

• blue line - nominal oil prices
• Yellow line - Real oil prices, adjusted for inflation

Since oil had become an intrinsic part of the economy, we had taken it for granted that oil could be bought cheaply. The 1960s and early 1970s, saw a rapid rise in ownership of cars and motoring. Britain enthusiastically embraced the motor car - helped by rising incomes and cheap petrol.

But, the 1973 oil crisis, changed all that. Suddenly the price of petrol more than doubled and the UK faced an energy crisis to go along with a spike in inflation. The government seemed powerless as Britain was put on a three day week and TV was turned off at 10.30pm. Emergency speed limits were introduced to conserve petrol.

If in 1957, we had never had it so good, by 1973, it seemed we had never had it so bad. It was a return to the 1940s austerity; but with no obvious enemy, the public were less forgiving of this inconvenience.

1976 IMF Bailout

In 1976, the UK needed to apply to the IMF for a bailout. This was due to high budget deficit and also concerns over value of Sterling. Markets believed Sterling was overvalued and so kept selling. This caused the Pound to depreciate.

Britain asked the IMF for a £2.3bn bail out in 1976 saying unemployment and inflation were at exceptional levels. IMF Briefing

In return the IMF insisted on deep spending cuts to tackle the budget deficit. The government implemented spending cuts. By 1977, the economy showed signs of recovery, and helped by oil revenues the balance of payments improved. The pound also strengthened after the loan. The UK did not need to drawout the full loan. IMF loan at National Archives

Recent Inflation Graph and blog posts

I have been updating a different economics blog.

What would a world without oil look like?

Debt spirals explained - the situation facing many EU countries

Why is current recession so severe?

What is the long run trend rate of economic growth? - has it been reduced in UK since recession?


Inflation in the UK remains relatively high given the state of the economy. Latest UK inflation

Europe's Deflation

A predictable, but nevertheless depressing, event is to see Europe slipping into deflation.

Monthly inflation in the EU area was -0.8% in January 2012. (EU Stat) The 12 month inflation figure was 2.6%, which includes some cost-push inflation. Inflation will continue to fall over the coming months However, there are few signs of economic recovery. Countries in the periphery of the EU are at greater risk of deflation because of the continued austerity, high exchange rate and fall in economic confidence. The ECB has been debating whether to pursue quantitative easing, but there is a deep-seated reluctance to pursue this unorthodox monetary policy.

The problem is that even quantitative easing can take a long time to have an effect on economic activity. The experience of the UK and US is hard to judge, but it has had an effect in preventing a deeper and longer lasting recession. Any fears of inflation resulting from quantitative easing seem hard to justify as the economies struggle along.

A short reminder of the timeline of the current economic crisis

How Will Deflation Affect the Eurozone?

• Increase Debt to GDP ratios. Falling nominal GDP will increase the debt to GDP ratio. Even if countries like Greece and Portugal manage a primary budget surplus (which is very hard to imagine), they would still see rising debt to GDP ratios, and probably a continuation of higher bond yields
• Decline in consumer Spending. Deflation plays a key role in delaying spending decisions. Faced with falling prices, people tend to delay spending, waiting for goods to become cheaper.
• Higher real Interest Rates. With deflation, real interest rates are effectively higher. 
• Higher unemployment. With continued deflation and lower growth, EU unemployment will remain high.
• More on economic costs of deflation.

Boom and Bust Economic Cycles

Definition of Boom and Bust: A period of rapid economic expansion which is unsustainable leading to subsequent period of economic contraction and recession.

The Great Moderation

Was the great moderation a period of boom and bust?

 

Inflation stayed low between 1992 and 2009. It wasn't a classic boom. Economic growth was positive, but it wasn't significantly higher than the long run trend rate. Inflation stayed low.

However, although growth and inflation were stable in the 1990s and 2000s, there were still components of a boom and bust.

Housing Boom and Bust

In the late 1990s and early 2000s, there was a housing boom and bust. UK House prices rose much faster than inflation until Summer 2007, when the credit crunch completely changed the nature of the mortgage market. As mortgages were withdrawn, house prices started to fall. But, because mortgage affordability was stretched, people were not able to save the new size of deposits. Because prices had risen so much they had a long way to fall. The fall in house prices has played a crucial role in knocking consumer spending and consumer confidence. It has directly led to job losses in construction and estate agents.

The boom and bust in housing is quite clear and has played a key role in the current bust.

Unbalanced Economy A boom and bust suggests an unbalanced economy. In the growth years of 2000-08, there was a strong growth in consumer spending and consumer borrowing. This is reflected in the:

• falling savings ratio
• Rise in mortgage equity withdrawal.
• Higher consumer borrowing
• current account deficit. - financed by hot money flows and higher interest rates.

In other words, the main cause of UK economic growth was consumer spending. The economic growth was not balanced throughout different sectors. Because saving rates are so low, it means that the UK is particularly sensitive to the rising living costs and tighter credit conditions.

Lawson boom and bust of the 1980s.

In the late 1980s economic growth increased to 5% a year in 1988 and 1989. This was far above the long run trend rate and this excessive growth caused inflation to rise to double figures. In response to the inflationary spiral, the government joined the ERM and increased interest rates. This reduced inflation, but, at the expense of switching the boom into a painful bust. House prices collapsed (not because of a financial crisis, but because interest rates were so high). Unemployment rose and the government dithered in stimulating the economy because it was pursuing an outdated target for sterling against the D-Mark. See Lawson boom
Implications of Boom and Bust.

The UK did have its longest period of economic expansion on record - 1992-2008. In part this was due to avoiding a boom and bust cycles which have been frequent in the post-war period. However, you could say there was a boom and bust cycle in financial markets. Lending rose rapidly, but this later proved unsustainable.

This recent crisis, raises the importance of looking beyond headline inflation and economic growth statistics. Low inflation is not the only factor we need to look at. It is a mistake to ignore house prices bank lending and other indicators of economic / financial volatility.
There is also a danger of relying on consumer spending to fuel growth.
There is also a danger of attracting hot money flows to finance a current account deficit. And there is a danger of allowing lending criteria to become so relaxed that any tightening creates economic problems. 

• Causes of the Business Cycle

European Recession

After the first European recession in 2009, the EU is heading back into another recession only three years later. But, this recession is much more worrying. There is less room for maneouvre, attempts to solve the debt crisis have failed, and have left countries with both low growth, but continuing debt problems.

The cause of the second recession is depressingly simple.

• Austerity policies really do cause a fall in aggregate demand, higher unemployment and lower economic growth
• If you cut government spending, you need something else to boost demand in the economy. This could be devaluation, loose monetary policy, higher exports or stronger private sector demand and investment. 
• However, Europe has only deflationary policies. There is no devaluation for southern economies, no loosening of monetary policy and with very low confidence, the private sector has not compensated for even minor spending cuts. 
• The German economy is doing relatively well (though GDP still fell 0.2% in the last quarter). But, the German economy is helped by very strong export demand. Germany has a current account surplus of 6% of GDP. The problem is that some feel everyone should follow German's model of exports and high current account surplus. But, not everyone can have a current account surplus! 
• The flipside of strong German exports is a current account deficit in Greece and Portugal of 10% of GDP. To help economic growth in Greece and Portugal, there needs to be a revaluation of trade within the EU - but that is very slow to occur with a single currency.
• In a liquidity trap and period of very low private confidence, the private sector haven't taken the place of spending cuts. It is why Italy has gone into recession with GDP falling 0.7% in last three months of 2011, following 0.4% contraction in three months before.

Austerity and Lower Tax Receipts

Since Greece increased taxes, and cut spending, VAT receipts have fallen 18% in 201. Simply because 60,000 firms went out of business. This is an example of how austerity policies can be self-defeating in a recession. (Tragedy of Greece)

Yet, Daniel Mitchell, of the libertarian-minded Cato Institute, argues that Europe has not been austere enough and that much more is needed. "European countries talk about austerity but they don't mean cuts," he says. (Guardian Link). At least the IMF are aware that there can be too much of a necessary thing. (IMF blog)

Youth unemployment of 50% - just cut government spending a bit more. This is the logical policy of free market economics.

Yet, despite all the austerity of Greece, Italy and Ireland, they have failed to solve the 'debt crisis'

Depressed with the European economy, I had a look at the Indian economy in 2012 - at quite a different stage of the economic cycle. What India needs is to reduce its budget deficit and liberalise its complex bureaucracy. If India can lears anything from Europe - don't wait for an economic downturn to try and solve persistent budget deficits.

Keynesian economics may support fiscal expansion during a recession, but in India's case, a very different approach is needed.

Related

• Causes of recession
• Euro debt crisis Explained

Outlook for Euro

A look at some of the challenges facing the Eurozone and why the Euro is likely to remain weak over coming months.

The Euro has been weak ever since the debt crisis began at the start of 2010.

Challenges for the Euro

1. Current Account Imbalances


The single currency has created economic imbalances in the Eurozone.

• Germany has a large current account surplus (almost 6%) - suggesting German exports are undervalued.
• By contrast, Greece has a current account deficit of 11%.
• Portugal has a current account deficit of over 7%.
• In Q3, the UK had a deterioration in current account deficit to 4% of GDP (despite devaluation since 2009.
• To restore competitiveness in Greece and Portugal without devaluation would require a prolonged period of deflation. This deflation would lead to lower growth and higher unemployment.

2. Government Debt

Greece and Ireland have a high budget deficit. But, it also shows that the problems of the Euro are more than debt. Portugal and Spain have high bond yields - despite a relatively low budget deficit. Portugal and Spain have a budget deficit 50% less than similar deficits in the UK and US. Yet, US and UK don't have rising bond yields.

• List of government debt by country

3. Unemployment

Unemployment rates in the Eurozone present a real threat to social stability - especially since unemployment is more concentrated amongst young workers.

4. Low Economic Growth

Growth forecasts for the Eurozone have been downgraded. For southern Europe, there will be a double dip recession, making it harder to reduce debt to GDP ratios and increasing unemployment. Unfortunately, it is hard to see a strategy for growth. There will be no loosening of monetary policy. The exchange rate will remain overvalued for the uncompetitive south. And at the same time, they have to reduce spending to tackle budget deficits. Combined with a European wide slowdown, it will be a slow and limited recovery.

Related

• Problems of the Euro

Predictions for Pound Sterling to Euro

Predictions for Pound Sterling to Euro in 2012

Readers Question: I read a lot about the Dollar/Pound relationship but I want to know what the forecast is going to be for Euro/Pound. What is the factor that determines the value of the Pound down against the Euro?

The Main factors determining the value of the Pound Sterling to Euro

• Relative interest rates - If UK interest rates are higher than Eurozone, this will attract hot money flows from Europe to UK. This will increase demand for sterling, and sterling will appreciate
• Prospects for economic growth. If the UK economy grows quicker than the Eurozone, we would expect UK interest rates to increase faster than in Euro, causing an appreciation in Sterling.
• Prospect for inflation. If UK inflation is higher than in Eurozone, it will make UK goods relatively less competitive than Euro goods. This will cause less demand for UK goods and a devaluation in the value of Sterling.
• Government Debt. If markets fear government default, this makes them less willing to hold currency which the debt is denominated. If markets feared the UK government may default, foreign investors would sell UK bonds, pushing down the value of the exchange rate.
  

Graph showing Value of Euro to Pound

Reasons Why the Pound Devalued against the Euro in 2008/09

1. UK Economy in steepest recession. The UK economy experienced a rapid drop in GDP (Steeper than even Great Depression of 1930s). The UK was particularly hard hit by credit crunch because of the UK's exposure to financial services. Because of the sharp slowdown in UK GDP interest rates were cut to 0.5% in March 2000
   Lower interest rates are very important for weakening a currency. Lower UK interest rates make it less attractive to buy Sterling and save the money in the UK. Therefore, there are less hot money flows and a weaker value of Pound.
2. Housing Market. The UK Housing Market plays a crucial role in determining consumer confidence, spending and economic growth. The fall in house prices has reduced consumer confidence and with house prices forecast to fall or stagnate in 2012, it is another factor which will keep interest rates low.
   
3. Credit Crisis. The UK is heavily exposed to the credit crisis because mortgage lending accounts for a high % of disposable income. Mortgage lending is more important in the UK than the Eurozone where mortgage payments account for a smaller % of disposable income. With less mortgages becoming available, demand for housing is falling. Also those with existing mortgages are seeing the cost of remortgaging increase. This is putting pressure on the Bank of England to reduce base rates to compensate for the increased bank rates. As they explained the recent interest rate cut:
   
   "The disruption in financial markets could lead to a slowdown in the economy that was sufficiently sharp to pull inflation below the target."
   
   
4. UK Current account deficit. Relative to the EU, the UK is running a current account deficit, which puts downward pressure on sterling because of the outflow of foreign currency. UK's current account deficit is still 4% of GDP (Q3 2011) despite devaluation.
   
5. Large Rise in Government Borrowing. With government bailouts, fiscal expansion and tax cuts, government borrowing will be close to 9% GDP in 2012/13. This causes lower confidence in the UK economy to pay off debt (though UK public sector debt is still lower than many of our European counterparts)
   

Predictions for Pound vs Euro in 2012

The Euro has become increasingly weak since the onset of the Euro debt crisis in early 2010. Markets fear default in countries like Greece, Italy and Portugal. This could lead to countries exiting the Euro. This uncertainty and fear over default has pushed the Euro lower. There is no quick fix to the Euro debt crisis. Efforts to reduce government borrowing have caused a slowdown in economic recovery and prospects of a double dip recession make markets more nervous over the Euro.
The UK's recovery is being held back by the Eurozone downturn. The UK is highly reliant on the EU for our exports. However, the UK still has greater flexibility than the Eurozone and recovery is likely to be stronger in the UK than in the south of Europe.

The strength of the Euro is also causing problems for EU exporters.

Conclusion

The Pound has fallen on the back of depressing economic statistics. The whole Global economy is likely to experience recession, but, the UK recession has been deeper than most. Against this backdrop the pound has been weaker.

Related:

• Outlook for Euro
• What causes a currency collapse?
  

Reference
Picture from : Guardian - Pound falls to record low

Should we Try and Save the Euro?

How much should we try to save the Euro?

Reasons to Save The Euro

1. Capital flows on Break up. The short term costs of a Euro break up, are potentially very high. The main problem would be massive capital flows from exiting countries (e.g. Greece, Italy)

If Italy left the Euro, Italian bond and Italian savings could see a 20-30% devaluation.
Therefore, investors with Italian bonds and savings will try to sell them and move their savings from Italy to other countries (e.g. Germany, UK, Switzerland and Japan)

This run on Italian banks could be devastating for Italy, but also have knock on effects on other European banks who would lose money through their exposure.

This European credit crunch would precipitate a fall in investment and economic output. To some extent the full scale of the financial fall out is difficult to predict because there are few if any precedents.

2. Other Benefits of the Euro. In comparison to what is happening in Europe now, these benefits seem rather insignificant. See benefits of Euro - but they are the reason for the Euro in the first place.

3. Intervention by ECB. Arguably if the ECB changed its policy stance and agreed to create money and buy bonds, it would be possible to save the Euro at much lower cost than the route of prolonged austerity.

Reasons Not To Save The Euro

The Euro is fundamentally flawed. Countries in Euro have become uncompetitive leading to lower growth and higher unemployment

Different Trends in Competitiveness

Harmonised competitive indicators in the EU (2011 Q1), source: ECB Stats based on unit labour costs indices for the total economy:

This shows how since 1998, Germany (DE) reduced costs by 18.5%. Greece by comparison saw a 9.7% increase in costs. (see more: Competitiveness in Europe) Yet they have the same currency! Therefore, there is inevitably an imbalance. Greek exports have become uncompetitive, but they can't devalue.

The result of competitiveness can be seen in statistics such as the current account.

Current Account deficits in the Euro

2. The Proposed Solution is not a solution

The only real solution offered by the EU, to the EUrozone crisis is to impose budget controls. Whether the Greek budget is managed by Germany directly or not. The message is clear - what we need is repeated spending cuts to meet budget targets. But, this is just a recipe for lower growth and rising GDP to debt ratios. The crisis is not just excessive government borrowing. If it was due to high budget deficits, why is the UK not seeing bond yields rise like Portugal?

It is the lack of competitiveness that the Euro can't deal with. The Euro is creating a climate of economic austerity, which inevitably leads to higher unemployment. Why seek to save a currency which isn't working.

3. The Euro has fundamental problems:

• Lack of independent monetary policy
• lack of exchange rate flexibility
• No lender of last resort causing greater turbulence in bond markets.
• The ECB is geared towards low inflation in Germany and has little interest in promoting growth in Southern Europe
  

See: Problems of Euro

Conclusion

It is a really difficult choice. Leaving the Euro could potentially be very damaging. It could lead to a very severe credit crunch and recession. But, patching up the Euro in its present form could lead to persistent high unemployment and low growth - especially in those countries with uncompetitive exchange rates.

Could the Euro work? Well it could in theory, but it's hard to see how the 16 countries can quickly come to economic harmonisation.

• Why does Euro try to save the Euro?
  

Reducing Government Borrowing

Readers Question: Bond yields are very low at the moment in the UK. Does it make economic sense to try to cut public borrowing at low interest rates only to push private borrowing, at high interest rates, up to higher and higher levels?  In my mind, the austerity measures are causing financial inequality to increase, as people are being pushed further and further into costly debt. It seems morally wrong if nothing else!

It is an interesting point. A justification for government borrowing is to boost aggregate demand in a recession to stimulate economic growth. In a recession, when many people are losing their jobs, government spending is a way to limit the impact of a recession. If you withdraw unemployment benefits (e.g. 1931) or cut spending then people respond by spending less, leading to lower economic growth and increased inequality.

It is argued in a liquidity trap demand for saving is high, even at low interest rates. In this case, the government can borrow more without pushing up interest rates. This has been the case in the UK and US since 2008. Despite rapid increase in levels of government debt, bond yields have fallen - as you would expect in a liquidity trap.

Countries which have pursued austerity policies aggressively have seen a fall in the rate of economic growth, leading to higher unemployment and lower tax revenues. Ironically, austerity measures have often failed to reassure markets and reduce debt to GDP ratios. (e.g. Portugal, Greece, Spain)
Reasons to Reduce Government Spending
You could argue, that given size of UK budget deficit, it is necessary to take steps to reduce it. If we didn't take some steps, then people may not want to buy UK bonds. This would push up interest rates on government debt. The Government may claim, that bond yields on UK debt are only low because they have a plan to reduce debt.

On the other hand, you could argue, that the government were too quick to reduce debt. They should have waited until the end of the recession, and liquidity trap. When the economy showed signs of real recovery - that is the time to pursue lower spending.

By cutting spending too hard too quickly, they have pushed some people into more private debt and caused a double dip recession which will make it even harder to reduce debt to GDP ratio.

How Much Can a Government Borrow?
A key question is how much can the government borrow? For example, recent budget deficits were a record for peace time. The government may argue the sheer size of the budget deficit meant that some spending cuts were necessary.

The government may also point to the Eurozone, where bond yields have been rising on fears of government default. See: EU bond yields In this climate, they argue we need to tackle the deficit.

However, you could argue higher debt yields in the Eurozone are due to structural problems in the Euro

• lack of competitiveness because of single currency and inability to devalue
• Lack of economic growth
• Lack of lender of last resort.

Therefore, outside the Euro, the UK doesn't need to fear rising bond yields because of higher government borrowing.

Another issue is total UK debt (private + Public sector). Total UK debt 500% is one of the highest in the world so the UK needs to make some progress at debt deleveraging - even if it is necessarily painful - but, that is a consequence of our past spending.

To answer your question. I believe the government reduced spending at the wrong time (economy still in recession). They should have targeted economic recovery has highest priority, and pursued debt reduction over a longer time frame.


Related

• What debt levels are dangerous?
• Does Government debt matter?

What Impact Has Quantitative Easing had on the Money Supply?

Since quantitative easing has been implemented, (£275bn of asset purchases by Bank of England using created money) UK narrow money (notes and coins) growth has been relatively stable.

M4 Lending and Retail Deposits

M4 lending and Liabilities to private sector have shown a negative growth rate since 2010.

M4 Growth has been much lower. If we exclude the impact of bond purchases, M4 growth has been negative.

M4 Lending (B62Q) , excluding the impact of securitisations, and excluding intermediate OFCs

This shows that banks have been reluctant to lend the extra reserves they gained from the Bank of England asset purchase scheme. It shows that underlying M4 money supply growth has been very low and at times negative.

Why Inflation?

To complicate matters, the UK saw a surge in headline inflation during 2011. CPI reaching 5.2%. However, this inflation was not caused by rapid growth in the money supply. It was caused by a combination of supply side factors, which caused a temporary blip.

• Higher import prices because of devaluation
• Impact of higher tax rates (e.g. VAT0
• Rising commodity prices, especially energy and oil.

Related

• Explaining Paradoxes of UK economy
  

UK debt passes 1 Trillion

Official UK public sector debt passed £1 trillion for the first time. This is equivalent to 64% of GDP.

• £1,004 billion.
• or £1,004,000 million
• or £1,004,000,000,000
• or if you prefer 2 billion iPhone 4 costing £499
  

• UK Public Sector debt

Does Debt Matter?

Does public sector debt of £1 trillion matter? Well, it depends. Here are some thoughts about whether we should worry about national debt and its impact on future generations.

It is concerning that UK private sector has been slow to fall. Overall UK indebtedness is one of the highest in the developing world. (McKinsey report on debt deleveraging)

Liquidity Trap Explained

A liquidity trap occurs when low / zero interest rates fail to stimulate consumer spending and monetary policy becomes ineffective. In this situation, 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 2009-11

In the UK, Base interest rates were cut to 0.5% in March 2009. For a considerable time, the economy remained in recession. Helped by quantitative easing and a devaluation in the Pound, there was a weak recovery in 2010. However, 2011 and 2012 saw a fall in the rate of economic growth. This period is a good example of a liquidity trap.

Interest rate cuts to 0.5% did little to create a strong economic recovery.

Money Supply Growth in Liquidity Trap

source: Bank of England

Despite quantitative easing boosting M4 growth by 10% in 2010, M4 growth has been very low. See also: Explaining Paradoxes of UK economy

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 practice 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 sub-prime 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.
• Banks Don't pass Base Rate cuts onto consumers
  

In liquidity trap, commercial banks may not pass base rate onto consumers.

How To Overcome A Liquidity Trap

• Quantitative Easing - policy to create money and reduce yields on government and corporate bonds
• Expansionary Fiscal Policy
• Overcoming Liquidity trap
  
• Higher Inflation Expectations
• Liquidity Trap and Fiscal Policy