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

IMF Economic Outlook 2012

The IMF definitely has its critics (see: Criticisms of the IMF). In the past the IMF has often been accused of imposing on countries harsh austerity measures, plus free market reforms, such as privatisation and spending cuts which have increased inequality and unemployment.

Recently, the IMF have often warned over the dangers of austerity measures which push economies back into recession. At the end of last year, Oliver Blanchard reported on dangers of self-defeating austerity (see: previous post: Is UK at risk from Eurozone crisis?) These seem a good evaluation of the situation, and it would be good if European politicians payed closer attention.

Yet, there are also inconsistencies in the IMF approach. Usually, if countries hard large current account deficits and negative growth, the IMF would advocate devaluation to restore competitiveness. But, despite record current account deficits in the Eurozone, the IMF still retain support for trying to make the Euro work. Thus, although theoretically, they are aware of the dangers of austerity and over-valuation, they haven't offered any alternative to the Eurozone.

As a consequence of the Euro crisis, the IMF have slashed its growth forecasts for the Eurozone for 2012 from economic growth of 1.1% to a recession with negative growth (-0.5%)

In southern Europe, the growth forecasts are even worse, with Italy forecast to show negative growth of 2.2%. The UK is forecast to stay in an effective 'growth recession' with feeble growth of 0.6% This is very poor given the negative output gap and rate of unemployment. But, it makes the UK have one of the highest growth rates in the EU (but - hardly cause for rejoicing). The main engines of growth will be China. More hopefully, is the predicted recovery of the US economy with growth of 1.8%.

Failure to Understand Deflationary Policies are Deflationary

Though the IMF have issued warnings about the dangers of rapid fiscal consolidation before economic recovery. The IMF, like other institutes have repeatedly underestimated the capacity for spending cuts and fiscal austerity to push economies back into recession.

The EU has expended considerable energy on the need for fiscal consolidation in southern Europe, without allowing for the impact on growth and tax revenues. This was a repeated theme of 2011 (Austerity in Europe) which at the moment shows no sign of changing.

Long Term Effects of Recession

A recession is a period of negative economic growth characterised by rising unemployment. In the short term, recessions can have various costs:

• Loss of income
• Firms going bankrupt.
• Psychological and health problems of the unemployed
• Higher government borrowing (lower tax receipts and higher benefit spending)

But, what about the long term effects of recession?

• Is there just a sweeping away of inefficient firms enabling a rebounding of economic growth and higher productivity? - or
• Is there a permanent loss of output and a persistent loss of economic welfare, even when the recession is officially over?
  

Long Term Effects of Recessions

Levels of Education. Studies in US, show that prolonged periods of unemployment lead to some students being unable to afford college education. It can also lead to lower levels of education amongst under 7s. If recession does effect levels of education then there will be a corresponding long-term effect on earnings of those affected. It will also lead to higher long-term inequality. Those without access to education will typically face lower income levels in later life.

• However, in the UK, student numbers have increased during the recession as students seek to avoid a difficult job market and go to university instead.. One factor is that education is more expensive in the US, therefore recession and lower income in the US leads to lower demand. However, as fees in the UK rise, recession may increasingly deter education.

Private Investment

Recessions have a significant deterrent effect on private investment. Investment has been particularly badly affected in the 2008-12 downturn because of limited access to bank credit. If the recession is prolonged, this can have a long-term impact on levels of capital and productive capacity.

Lost Output

In some short-lived recessions, output has often bounced back and caught up with the lost output. This has enabled the economy to keep the long-run trend rate of growth. For example, in 1994, the UK economy grew by nearly 4% which helped catch up 'lost output' of the 1991-92 recession, and maintain a long-run trend rate of 2.5%.

Bounce after recession of 1981 and 1991.

However, with a longer 'balance sheet recession', there is evidence that output has been permanently lost. This balance sheet recession has not just been a temporary fall in demand due to higher interest rates. It has involved a credit crunch, lower bank lending, and falling asset prices. It has lasted much longer and caused a much more prolonged fall in GDP.

Europe's Lost Output

source: Europe's Gap

US Output and Potential Output

source

Even the most optimistic forecasts for recovery suggest slow growth. There is going to be no bounce to catch up with lost output. The longer the recession lasts, the greater the risk that output will fall below the trend of potential output.

Business

Recessions make it more difficult for new firms to start. There are examples of firms who have been able to start in the middle of a recession (Microsoft 1975), CNN (1980) Disney (1923). But, in recession, typically business-starts fall dramatically. Also existing firms are at risk of bankruptcy. In 2008 in the US, 43,500 businesses filed for bankruptcy, up from 28,300 businesses in 2007. Some argue that a recession 'weeds out' inefficient firms. But, even good, efficient firms can go out of business due to temporary liquidity problems.

It is possible, some firms merely delay start-up, but for some firms, a few years may mean the window of opportunity passes and two years later is too late.

Impact on Government Borrowing

This permanently lost output also means permanently lost tax revenues. In this current recession, many economies have felt the need to reduce government spending as a result of the cyclical increase in their budget deficit (especially countries in the Eurozone). However, this cut in government spending has adversely affected capital investment and the rate of economic growth. It is part of the reason why the recession has been difficult to overcome. Therefore, if recessions cause an unsustainable rise in government borrowing, it may cause governments (rightly or wrongly) to cut spending and increase taxes which further damages economic growth in both the short term and long-term.

Inequality

The biggest cause of inequality and relative poverty is unemployment. A rise in in unemployment leads to lower income and can harm nutritional intake and quality of life. In the US, there are also impacts upon health care, with unemployment causing a fall in health care insurance. Poorer health care and nutritional levels can impact in the long-term.

Impact on Younger Generation

Effects of recession on younger workers. source

A recession tends to have a greater impact on younger workers rather than older workers.
In the long term, this will impact young peoples future earning potential. It is hard to recovery from a period of unemployment in early working life. It leaves a gap in your CV and damages future employment and promotion prospects.

In addition, highly concentrated youth unemployment can lead to a rise in social problems. Higher unemployment rates can lead to higher rates of crime, vandalism and social dissatisfaction. This feeling of social exclusion can be difficult to eradicate when the economy gets out of recession.

• A culture of unemployment amongst young people definitely has long-term effects.

Related

• What determines the long-term effects of recession?
  
• Causes of recession
• Problems of recovering from recession
  

Link Between Inflation and Interest rates

• Interest rates can influence the rate of inflation and the rate of economic growth.
• The Bank of England change the 'base' interest rate to try and target the government's inflation rate of 2% +/-1

• Generally, an increase in inflation, leads to higher interest rates.
• A fall in inflation rate, and lower growth leads to lower interest rates.

Graph Showing Inflation and Interest Rates in the UK

Real Interest Rates

• Typically, nominal interest rates are 1 - 2 % higher than inflation. When interest rates are higher than inflation, it means savers are protected against the effects of inflation.
• However, in 2008 and 2011, we had a period of negative real interest rates. This meant the inflation rate was higher than the base rate.
  
• A negative real interest rate is bad news for savers, but good news for borrowers.
  

Response to Rising Inflation

• If inflation rises, generally, the Bank of England increase interest rates to reduce inflationary pressure.
  
• Higher interest rates tend to reduce consumer spending. This is because homeowners see an increase in the cost of their mortgage payments and have less disposable income. Therefore, they spend less. Also, higher interest rates increase the incentive to save and reduce the incentive to borrow.
• Therefore, an increase in interest rates tends to reduce the rate of economic growth and prevent inflationary pressures.
• See more on: Effects of Higher interest rates on economy
  

Response to Fall in Inflation Rate

If inflation falls below the target, there is likely to be a fall in the rate of economic growth, and the Central Bank may fear a recession. Therefore, in response they may cut interest rates to try and boost economic growth.

• Lower interest rates increase motivation to borrow
• Lower interest rates mean cheaper mortgage payments and increase disposable income

Why A Cut in Interest Rates May Not Work

In some situations, cutting interest rates may be ineffective in boosting economic growth. For example, in 2008-11:

• The recession was so sharp, that investment and consumption have fallen dramatically and so the cuts in interest rates have only mitigated the extent of the downturn
• House Price falls provide a powerful negative impact on spending. Lower interest rates should boost spending. But, with house prices falling 20% since the peak, this has reduce consumer wealth and therefore reduced spending.
• Global downturn. Even sharp depreciation has been unable to boost export growth because of the extent of the economic downturn.
• Time Lags. A cut in interest rates can take a long time to have an effect. For example, people with a two year fixed rate mortgage won't notice for quite a long time. (until they re-mortgage. Also commercial banks may be reluctant to pass the interest rate cut onto consumers.

Why Higher Inflation May not Cause Higher Interest rates

• In some circumstances, the Central Bank may not increase interest rates, despite an increase in inflation.
• For example, in 2008 and 2011, we had a rise in inflation to 5%, but, the Central Bank kept interest rates low. Why?

They kept interest rates low because:

• They felt inflation was just due to temporary cost-push factors like higher taxes and volatile food prices increasing
• They felt economy was at risk of inflation. Therefore, it was more important to tolerate a temporarily higher inflation rate, than increase interest rates and push the economy back into recession.
  

Related

• Interest rates and the economy
• Latest interest rate and inflation predictions
  
• Does low inflation always mean low interest rates?
• Real Interest rates
• Understanding interest rates
  

Is UK at Risk from Eurozone Crisis?

In his New Year's message, David Cameron declared Britain can only gain 'some protection' from the Eurozone debt crisis. Despite deep spending cuts, Cameron admits it might not be enough to prevent problems from Europe spreading to the UK.

I'm not a great fan of credit rating agencies, but it was interesting that Moody said the threat to the UK's debt position came from prospects of a double dip recession (and not a failure to cut spending more).

In other words, the fall in economic growth that has occurred since the start of 2011, is the biggest threat to the ability to satisfactorily reduce debt to GDP ratio.

UK public sector debt is currently 62% of GDP. How did the UK deal with its public sector debt of over 200% which occurred in the early 1950s - Debt which was a legacy of the Second World War and bold spending on the Welfare state post 1945?

One reason was a loan from the US (who were fearful of a Communist governments springing up in Europe). Today, there is no chance of similar loan from the US. But, the US loan is only part of the story. The main reason is that the UK were enable to maintain two decades of fairly constant economic growth. The rise in GDP, meant that the government could steadily reduce debt to GDP, without resorting to spending cuts. It is a similar story in the US, whose large national debt post 1945 was steadily reduced over next few decades.

An elected government of 1945 could easily have panicked at levels of national debt in the aftermath of Second World War. They could have used these debt levels as an excuse to cut spending (rather than setting up NHS and Welfare State). But, spending cuts in the 1940s, would have caused a very different economic recovery. With aggressive spending cuts, the UK economic growth would have been much lower, tax receipts would have been smaller, it would have been much more difficult to reduce debt to GDP ratio.

The mistake the UK made in 2009 was to consolidate too fast. Outside the Eurozone, the UK never had a surge in bond yields. Countries which pursued austerity with vigour singularly failed to prevent surging bond yields. As Oliver Blanchard of IMF said (Four hard truths):

To the extent that governments feel they have to respond to markets, they may be induced to consolidate too fast, even from the narrow point of view of debt sustainability.

They (markets) react positively to news of fiscal consolidation, but then react negatively later, when consolidation leads to lower growth—which it often does.

Not all is negative. In 2012, falling inflation will reduce the squeeze on living standards. But, with a renewed slowdown in Europe, it will be much harder to boost economic growth and reduce unemployment.

Yes, the UK is at risk from the Eurozone crisis. A fall in exports to Europe would reduce economic growth, when it is already stagnant. Also, prolonged crisis in Europe can only adversely affect UK confidence.

2012, will be a tough year.

British vs French Economy

A good Central Banker is supposed to be boring. But, the French are trying to make it a little more interesting by suggesting other economies are even worse than theirs. A kind of playground, 'my Dad earns more money than your dad'

Christian Noyer, the head of the Bank of France said: "When I look at our British friends, who are even more indebted than us and carrying a bigger deficit, what I see is that the ratings agencies so far don't seem to have noticed."

Now, the rating agencies have a pretty poor track record. It wouldn't be the first time the rating agencies have given a triple AAA rating where it wasn't deserved. Yet, the markets seem to agree with the rating agencies. Despite a bigger budget deficit, bond yields on UK debt have fallen in 2011, in France they have risen. There is great fear of any Euro bond (apart from Germany). But, outside of the Euro, the UK has been relatively insulated.



The difference between British and French situation is that France is in the Single Currency, the UK isn't. And it's rather worrying that the head of the Bank of France hasn't understood why there has been a sharp divergence in bond yields between Eurozone members and those outside.



It may be unfair. Perhaps UK doesn't 'deserve' such a low bond yield compared to other European countries. Perhaps the UK was just lucky to stay out of Euro. But, that's the drawback of being in a single currency, with no lender of last resort and no ability to devalue. The problem is that the EU never give the impression they appreciate why they are in such difficulty.

The American credit rating agency Fitch, concluded that a "comprehensive solution" to the eurozone crisis was "technically and politically beyond reach" And I tend to agree with them.

French National Debt

UK National Debt


UK debt has been increasing at a faster rate because of a bigger budget deficit.

• UK national debt
• French national debt

UK Economic Snapshot end of 2011

On my other blog, I published a range of graphs and data on current state of UK economy, and likely outcome in 2012. A look at current state of UK economy with forecasts for 2012

Rising inflation and unemployment.

UK Inflation 2012

Real Wages

Related

• UK Economy in 2012

Policies to Improve Eurozone economy

Readers Question: I read a lot about two suggested solutions to the Euro zone that seem to contradict each other:

1. Internal devaluation to restore competitiveness (which means wage and price deflation).
2. Create more inflation that will reduce debt overhang in real terms.

If you choose to 'deflate' you will gain competitiveness but will also increase debts in real terms, which could discourage spending. On the other hand, inflating debts will reduce them in real terms, but will further hurt competitiveness. How do you reconcile the two?

Internal Devaluation

At the moment, the Eurozone is choosing option one - internal devaluation.

There are many factors which are pushing Eurozone inflation lower.

• Spending cuts and attempts to reduce budget deficits.
• Wage freezes or wage cuts put downward pressure on wage inflation.
  
• Countries which are uncompetitive can't devalue to improve competitiveness. Therefore, inflation is pushed lower.

The problem for the Eurozone is that many Eurozone economies face substantially higher costs and uncompetitiveness. Spain, Italy and Greece are perhaps 20% overvalued. To restore competitiveness by internal devaluation means they face several years of low growth, high unemployment and social unrest.

Deflation increases Real Value of Debt

Yes, you are correct that deflation, would increase the real value of debt. Deflation will, ceteris paribus, increased debt to GDP ratios in these countries. They will have to devote more tax revenue to interest payments. It becomes a vicious cycle of austerity, lower growth and lower tax revenues.

If they had their own currency (like Iceland or UK) they could immediately restore competitiveness through a devaluation.

Eventually, internal devaluation will help to restore competitiveness and their will be economic growth of sorts. This process can be quicker and less painful if

• Labour markets are flexible
• Supply side policies to increase labour productivity and flexibility
• The working population agrees to the austerity
  

So far, Ireland has been less prone to striking than Greece or Italy.

Inflation

I would say the policy is not so much just to create inflation, but to put a higher priority on increasing nominal GDP, even if it leads to a little inflation. This may involve more expansionary monetary and fiscal policy. (i.e. not increasing interest rates in 2011 like ECB did).
The benefits of targeting higher nominal GDP

• Debt to GDP ratios reduce
• Higher economic growth helps reduce budget deficit in a much less painful way than spending cuts.
• Arguably, higher growth and tackling EU's chronic unemployment problem should be the highest priority.

There are risks involved in targeting higher inflation. If inflation became deep-seated it does have costs and can be difficult to reduce. But, at the moment, inflation is not a problem. Core-inflation is below target, and in 2012, there are only going to be more deflationary pressures.

See: Inflating away our debt

Combination of Policies

I feel the Eurozone needs a combination of policies

1. Target higher economic growth (higher nominal and real GDP)
   
2. Reduce pace of fiscal austerity (ECB should buy bonds and create money to reduce pressure for immediate spending cuts)
3. Supply side reforms to improve labour market flexibility in southern Europe.
4. Long term fiscal change which deals with long-term spending entitlements (e.g. higher pension age) will help improve long-term structural deficit without harming current growth.

The best solution would be higher economic growth, combined with increased productivity amongst uncompetitive countries. But, the problem is in a single currency, to actually restore competitiveness through internal devaluation takes a long time.

• Options for Eurozone
  

Outlook for UK Economy 2012

The Bank of England have done a good job in avoiding the temptation to tighten monetary policy, despite having to tolerate headline inflation rate of over 5%. Underlying core inflation has always been on target. There is no sign of wage inflation like in the 1970s or 1980s. To have tightened monetary policy in 2011, would have only made the recession deeper. In 2012, inflation is likely to fall considerably.

Inflation



After peaking at over 5% in 2011, UK inflation is set to drop sharply in 2012. This is because the inflation of 2011 was due to temporary cost push factors. By mid 2012, these will have vanished from the 12 month index. The temporary inflation has not changed inflation expectations, and it certainly hasn't caused wage inflation.

As a result, interest rates are likely to be held at 0.5% throughout 2012, unless there is an unexpectedly strong recovery

Economic Growth


Despite £275bn of quantitative easing, some forecasters, such as the OECD, predict the UK will slip back into recession in 2012. This prediction of recession in 2012 shows the limitation of quantitative easing and the limitation of monetary policy. (see: problems of quantitative easing) Despite the efforts of the Bank of England to keep interest rates low and create extra money, this has only had a limited impact on economy. There have been much greater deflationary pressures in the UK. These include:

• Government spending cuts
• Rise in unemployment to over 2.64 million.
• Squeeze in living standards from falling real wages
• Recession and uncertainty in Europe

Official groups like the Bank of England and OBR still predict the UK will avoid negative growth, but even most optimistic growth forecasts stick to growth of less than 1%. This will be insufficient to reduce unemployment. It will feel like a recession.

UK House Prices

UK house prices are likely to remain stagnant. Only the limited supply and low interest rates are preventing sharp falls in house prices to reflect the absence of demand (especially from first time buyers who are being squeezed out of market).

UK Isolated in Europe?

I follow economic news closely. But, if I think it is just politics, I gloss over it. I'm only interested in economics. Therefore, the recent European Treaty business, seems a bit of a non-event. I don't really see what the EU have proposed to 'save the Euro' I only see a recipe for prolonged austerity, low growth and deflationary pressure.

The Deal Excludes:

• No real Fiscal union with a common Eurobond which would mutualise the debt.
• No attempt to make ECB lender of last resort and help reduce interest rate yields and make markets have more confidence in Eurozone debt.
• No attempt to deal with fundamental disequilibrium in the Eurozone which is at the heart of the crisis. (Southern economies with overvalued exchange rate and suffering from fundamental lack of competitiveness and low growth)
• No plan to target a higher rate of economic growth and reduce unemployment.
  

The deal still assumes that the problem is only irresponsible spending and an issue of high government debt. It ignores the fact that Spain and Ireland had very low levels of debt at the start of the crisis.

The deal only seems to be a glorified 'growth and stability pact' with stricter rules and penalties for exceeding budget deficits. But, this growth and stability pact doesn't deal with the fundamental cause of the Euro problem with is this two speed Eurozone economy.

A disequilibrium between different areas in the Eurozone.

From a political perspective, Britain may have been moved to the edge of the EU. But, from an economic perspective, there already is a two speed Eurozone.

Relying only on stricter budget deficit penalties is recipe for either political wrangling about foreign interference in national budgets and or a recipe for prolonged spending cuts, austerity and lower economic growth.

It is unfortunate, if we lack a degree of harmony and understanding with our European neighbours, but there are some things which it might be better to be isolated from.

Related

• Two Speed Europe
• Problems of Eurozone
  

European Inflation

Graph showing inflation in EU. Source: Eurostat

German inflation has been very close to the EU average. German inflation is currently 2.9%

The interesting thing is that, even as late as July 2011, the ECB responded to the 'threat of inflation' by increasing interest rates. This was despite increasing evidence of a double dip recession.

Source: ONS

By contrast, the Bank of England have tolerated a much higher inflation rate. They have not increased interest rates from the low of 0.5%, but have pursued another round of quantitative easing.

This reflects different approaches to the management of the economy.

The ECB were worried that the temporary blip in inflation would lead to higher inflation expectations and feed through into a real inflation problem. Therefore, they took preventative action and increased interest rates.

Source: Eurostat

This graph shows 'core inflation' in the Eurozone was below target. But, the ECB still increased interest rates.

The rate rise to 1.5%, may seem small, but it sent a clear signal about the ECB's priorities. They were willing to tighten monetary policy - even if this risked underlying deflationary pressure.

The Bank of England, argued that the rise in inflation was purely due to temporary factors, and in 2012, the problem will be that inflation will rapidly fall below the government's target of 2%.

source: Eurostat

Deflationary Pressures in Europe

It is likely that the Eurozone will also see a rapid drop in inflation to close to 0% in 2012. This is because

• End of temporary cost push factors such as rising oil prices
• Underlying wage inflation is very low.
• Austerity measures - European wide spending cuts will cause higher unemployment and lower economic growth.
• The Euro is still strong making many countries, especially in south uncompetitive.
• There is no outlet for boosting demand in the Eurozone apart from internal deflation.

I agreed with the Bank of England stance, and believe the slowdown in growth that has occurred in 2012 will cause inflation to plummet in 2012. By contrast, the ECB have made a mistake, the result will be lower growth and higher unemployment, especially in the periphery areas of Europe.

More on this topic: ECB v Bank of England

How Does Austerity Affect the Economy?

Several countries have recently implemented 'austerity packages' - attempts to reduce government spending and increase taxes, in an effort to reduce their budget deficit. It was hoped, these austerity packages would 'restore confidence', improve countries fiscal position and enable long-term recovery.

austerity in the 1930s

Main Impact of Austerity

Lower Demand. A cut in government spending and higher taxes will lead to lower aggregate demand and lower economic growth. If there is a fall in output, firms will employ less workers leading to higher unemployment. Also, government spending cuts may involve making public sector workers redundant. In addition, media coverage of 'austerity measures' tend to reduce consumer and business confidence. Fears over job losses and expectations of lower growth will encourage consumers to save rather than spend . This will be a further drag on consumer spending and economic growth (paradox of thrift). As a result of austerity measures in 2011, the OECD now forecast negative growth of -0.8% for the Eurozone in 2012.

Lower inflation. Spending cuts will tend to lead to lower inflation. Firstly, the fall in aggregate demand (AD) will lead to lower inflationary pressures in the economy. Also, if the government limits public sector wages, this will put downward pressure on wages. Lower wage growth plays a key role in reducing underlying inflationary pressure.

Competitiveness. It is hoped that austerity measures will help create greater pressure to reduce costs. These lower costs can help improve competitiveness. This is important for countries in the Euro, such as Ireland, Greece and Spain. In the boom years, they became uncompetitive leading to lower export demand and a current account deficit. Measures to deflate the economy should make exports more competitive. Ireland has been relatively successful in improving competitiveness, this is reflected in their move from a trade deficit to trade surplus in recent months. However, this attempt to improve competitiveness through lower inflation may take several years, and involve a high cost of lower growth and unemployment.

Irish GNP

source: Ireland Triumphs, NY Times, Krugman, P.

Ireland has been one of more 'successful' countries which has embarked on austerity, but this shows GNP is still significantly below pre-crisis levels (when real GNP was growing at an average rate of close to 5% a year)

Budget Deficit. Higher taxes and lower spending will lead to an improvement in the government's budget deficit. This will help improve public finances in the long term.

However, if austerity measures cause lower economic growth, the government will also see a fall in cyclical tax revenues. e.g. increasing tax rates, should increase revenue. But, if higher taxes cause a recession, there will be less people working and so income tax revenue may actually fall. Also, if austerity measures cause unemployment, it will require higher government spending on benefits.

For example, the UK's budget deficit fell slower than expected. This was partly because growth forecasts proved overly-optimistic. The austerity measures led to a slowdown in growth.

What Determines the Impact of Austerity?

Labour market flexibility. If labour markets are flexible, it may be easier to cut wages, and labour costs. This may make it easier to restore competitiveness and restore economic growth. However, if there is great resistance to lower labour costs, it will be much harder to restore competitiveness.

What Spending is Cut? If a government cuts spending by raising the retirement age to 70, then this will not lead to lower growth. In fact it could help increase labour supply and increase productivity. However, if the government cut spending on current infrastructure investment, this will have a much greater impact on reducing domestic demand and lead to lower economic growth.

Monetary policy. Austerity involves lower domestic demand. However, if monetary policy can be loosened (e.g. lower interest rates or increased money supply) then the deflationary effects of spending cuts can be offset. For example, in the Euro, countries like Greece have fiscal austerity, but there is no corresponding loosening of monetary policy (e.g. the ECB increased interest rates in early 2011 and didn't pursue any quantitative easing). By contrast, the UK has more flexibility because the Bank of England pursued quantitative easing.

Exchange Rate. Austerity is not as damaging if a country can devalue the exchange rate. This devaluation helps to restore competitiveness much quicker than relying on internal devaluation. The depreciation helps boost export demand. Countries in the Euro, can't devalue and so have to rely solely on internal devaluation to restore competitiveness.

Global Growth. Austerity is not as damaging if the rest of the world economy is doing well. If global growth is strong, export demand will be strong. However, if all countries are experiencing a recession, then deflationary fiscal policy will have a greater impact in reducing domestic demand.

Central Bank Intervention. Countries in the Euro, without a lender of last resort, are having to cut spending much quicker than countries outside the Euro. This is because bond yields on Euro debt has risen very quickly because markets fear liquidity shortages.

Related

• Timing of Austerity measures
• Euro debt crisis