The Lawson Boom of the late 1980s

Between 1985 - 1988, economic growth was well above the long run trend rate of 2.5%. By 1990, inflation had increased to 9.5%.

• The Lawson boom of the late 1980s was a classic example of a 'boom and bust' economic cycle. The late 1980s were a period of rapid economic expansion. This was caused by rising house prices, tax cuts, lower interest rates and high confidence. However, the boom cause a rise in inflation and a larger current account deficit.
• Policies to tackle this inflation caused the recession of 1991-92.

The Lawson boom followed from the devastating recession of 1981. This recession particularly affected the manufacturing sector, and caused unemployment to rise to 3 million. By 1985, unemployment was still over 2.5 million people. However, from 1986 the government made various decisions which helped to inflate the economy causing an inflationary boom.

Causes of the Lawson Boom

Tax Cuts

In 1988, the chancellor Nigel Lawson reduced the basic rate of income tax from 29% to 25%. The higher rate of income tax was cut to 40%. The tax cuts were so large, the 1988 budget is often referred to as the 'giveaway budget'.

The effect of these tax cuts was a fiscal stimulus which helped to increase disposable income and consumer confidence. This led to a rise in consumer spending and economic growth.

Over Optimism

During the 1980s, the government felt that they had presided over an 'economic miracle'. They felt that the last recession had removed a lot of inefficient firms. They also felt that supply side policies, such as privatisation, had been effective in increasing the productivity of the economy, and therefore had increased the long run trend rate of growth. This belief in their own success encouraged them to believe the economy could grow at a much faster rate than previously. Therefore, when growth increased above 4%, they did little to slow down an overheating economy. They believed (or hoped) that the long run trend rate of economic growth had miraculously increased from 2.5% to 4%. As Nigel Lawson said in his budget speech 1988.

In 1987 as a whole, output grew by getting on for 4½ per cent., rather more than the rate of inflation which averaged 4.2 per cent. At the same time, unemployment fell faster than in any other year since the war, in every region of the country, and more than in any other major nation.
The plain fact is that the British economy has been transformed. Prudent financial policies have given business and industry the confidence to expand, while supply side reforms have progressively removed the barriers to enterprise. (source)

However, this was not the case. The economic miracle had failed to materialise.

A Reluctance to Increase Interest Rates

In the 1980s, interest rates were set by the Chancellor (not the independent Bank of England, like now) In October 1987 there was a stock market crash. In one week 25% of the stock market value was wiped out. There was no obvious economic cause of this. But, the government was worried of its macro economic implications. As a result interest rates were reduced, to avoid any downturn. As it happened the stock market crash had little macro economic effect and the economy continued to grow very fast.

Exchange Rate Mechanism ERM

This was another factor keeping interest rates lower than they should. Mrs Thatcher didn't want to join the ERM, however the Chancellor Nigel Lawson wanted to follow an unofficial exchange rate of 3 DM to £1. This often proved to be a factor in preventing interest rates from rising. The Chancellor didn't want to increase interest rates because it would break the 'unofficial exchange rate'

The Housing Boom

The relatively low interest rates and the high consumer confidence sparked a housing boom. During the boom years, house prices rose by 300% (and more in places like London). Q4 1988 was the peak of the boom period with house prices rising over 30% at an annual rate. This boom in house prices caused a rise in household wealth and increased confidence. Equity withdrawal rose to record levels, which helped increase consumer spending.

 

Rising interest rates meant mortgage payments in the late 1980s took over 50% of disposable income

By 1988 and 1989, the economy was growing at 5% a year (almost double the long run trend rate) Despite signs of overheating, the government were reluctant to react. Interest rates were increased, but not as quickly as they could have. Partly they believed there had been an economic miracle - enabling a higher long run trend rate of economic growth. But, also Nigel Lawson, didn't want higher interest rates to boost the value of the Pound above the 'unofficial exchange rate' he was following. This was a policy known as shadowing the D-Mark. However, the fast growth meant that inflation started to creep up, eventually reaching 11% in 1990. With inflation at 11%, interest rates were increased further, but this caused mortgage payments to increase and the confidence evaporated as many people found they couldn't afford the mortgage repayments.

Current Account Deficit





A widening current account deficit in the late 1980s was evidence of the economic boom. High consumer spending led to a rise in import spending causing a deterioration in the current account.

Higher growth led to a bigger current account deficit. In 1989, the current account was 4.9% of GDP - reflecting the fact the economy was overheating and consumers were buying from abroad.

Related

• UK economy under Mrs Thatcher 1979-1984
• Lawson Boom at Wikipedia
• The awful warning of the Lawson Boom - pdf

Economic Effects of Freezing Subprime Mortgage Rates

Readers Question: Bush proposal to freeze down rates on subprime, will this have any impact in the future regarding our economy and is it going to have political consequences?

The problem with subprime mortgages is that many homeowners are coming to the end of their 'introductory period' In this introductory period, the mortgage interest rate is very low (the incentive to buy the mortgage) However, when the introductory period ends, it means they move to a much higher interest payment. It is feared that upto 500,000 homeowners could be at risk of defaulting leading to home repossession. This would have serious economic consequences.

1. Decline in Consumer Spending. People who face higher mortgage payment will spend less, causing a fall in economic growth. With the economy close to recession, this could be a decisive factor.
2. Losses for Mortgage Companies. If homeowners default on mortgages, banks will lose more money related to subprime. True, they can repossess the house, but with falling house prices this is little comfort.
3. Financial losses. It is not just mortgage companies who will lose out on mortgage defaults, many high street banks have bought 'subprime' debt so they will also be affected. This will lead to a tightening of credit for the average consumer
4. Falls in House Prices. If more homeowners do default on their mortgage payments it will cause further falls in house prices. (People will be selling not buying). Falling house prices will definitely reduce US consumer confidence and US consumer spending making a recession more likely.

The plan to freeze subprime interest rates for 5 years, could be a way to avoid some of these effects. From what I understand, the plan is voluntary and banks have no compulsion to join the scheme. However, it may be in their best interests to join, rather than suffer more repossession and loan defaults.

Moral Hazard.

There is an argument that this plan encourages irresponsible lending. Banks have made a mistake in lending so much mortgages, if they can avoid the consequences it may encourage them to do the same.

Political Effects.

I think the plan has some merit, it doesn't use taxpayers money, because it is a voluntary scheme. It is really the mortgage industry acting in its own interests.

Note: the recent interest rate cut by the Fed, will increase the likelyhood that the scheme will be successful.

Bush Freeze on subprime rates at Times

Advantages of Tax Cuts

Readers Question: What the benefits and the negative effects of reducing all taxes?

The idea of cutting all taxes is key element of libertarian politics. Cutting taxes is often a mantra repeated by conservative parties, although in practice, they usually find it more difficult to cut taxes than their rhetoric would suggest.

Firstly Cutting all taxes has an opportunity cost it requires either:

1. Cutting Government Spending


2. Increasing Government Borrowing

Of the two, cutting government spending, is the only policy which is sustainable in the long term.

Benefits of Tax Cuts

1. Government inefficient. It is argued the private sector is more efficient in spending money than the public sector. Government spending tends to be wasted, with high bureaucracy costs.


2. Lower taxes can increase incentives to work. It is argued lower income taxes will encourage people to work longer hours and new people to enter the labour force. Lower corporation tax will encourage firms to invest in the country.


3. Laffer Curve. It is even argued that cutting taxes can even increase government revenue. This is because if taxes are too high people don't work, so don't pay taxes. However, if people do work more, the government can actually gain more revenue.

Problems of Tax Cuts

1. Difficult to Cut Spending. The main problem that governments have faced when in power, is that cutting spending is actually very difficult. When you are in opposition it is very easy to say that their are too many 'benefit seekers'. It is easy to say, the government spend too much money. But, when you actually try to significantly cut spending it proves much more difficult because it will annoy some group.


2. Increased Inequality. Cutting taxes can also lead to the danger of increasing inequality because a lot of government spending is targeted to lower income groups. It also depends on the type of tax cuts.


3. Cutting Taxes rarely increases incentives. The Reagan administration hoped cutting income tax would stimulate supply side improvements, in practice it caused an increase in government borrowing. If you cut income tax, people don't necessarily work more (there are 2 effects: the income and substitution effect at work)


4. Taxes can be used to discourage spending of demerit goods. E.g. taxes on alcohol and cigarettes can be useful for discouraging their consumption.


5. Lower Taxes can lead to higher cost elsewhere. Generally, the US has a lower tax burden than the Europe. However, although Americans have lower taxes they have to pay for private health care insurance. However, they are also paying a profit margin to private companies. The Americans spend more on health care than any other nation, but, they have still patchy coverage. I would suggest that America should increase taxes and pay for health care from government spending - it would be more efficient and equitable.

Related:

Can Tax Cuts avoid Recession
Should taxes on Cigarettes be Increased?

Questions on Economics You've Always Wanted to Ask

If you've never studied Economics, (or maybe you did study Economics, but never understood it) this article hopes to be a brief guide to understanding the basics of what is going on in the economy. It is part of a blog writing project by Daily Blogging Tips. Some of the material may be familiar to regular readers, but these are some of the most common questions asked about the economy at the moment. Hopefully, they will answer some common questions on Economics.

What is a Recession and is America in a recession?

A recession is a period of negative economic growth, it means output and average incomes will fall. A recession will lead to higher unemployment and a decline in living standards. The US is not currently in a recession, because the economy is still expanding; however, there are fears it will enter into a recession soon. It is argued falling house prices and other factors, will lead to a decline in consumer spending and this could lead to a fall in output.

How Much Debt does the Government have and why do they borrow so much?

The US national debt is about $9,000 bn and growing. This equates to 65% of National GDP. The US government owe more money than the combined size of several medium sized economy. This debt is also likely to get bigger if the US goes into a recession.

• The main reason governments tend to borrow so much is political factors. A presidential candidate would not become popular by promising to increase taxes and cut spending (what is required to balance the budget). Cutting taxes and increasing spending tend to be more politically popular. However, the drawback is that the government have to pay interest on the debt. In 2007, over $430bn a year was spent on just paying interest payments on the government debt. - Just think what could be done with $430bn a year...
  

• The funny thing is that governments will think nothing of lecturing their citizens about the need to save and avoid irresponsible borrowing.

What is the Sub Prime Crisis?

In the early 00s interest rates in the US were very low (1.5%) and house prices were rising. Many people thought house prices would always rise forever. Therefore, many mortgage companies tried to sell as many mortgages as possible. They used aggressive sales techniques to sell mortgages to people on low incomes, often with bad credit histories (and often immigrants). The mortgage products were attractive for the first year or two, but, then become much more expensive. (but, this often wasn't explained).

A couple of years later interest rates increased and house prices stopped growing. Many people on low incomes could no longer afford their mortgage payments which had suddenly shot up. Therefore, many people with subprime mortgages defaulted (i.e. stopped paying) Therefore, banks who had lent money for mortgages lost it all. Billions of dollars has been lost in mortgage defaults. However, it didn't just effect the mortgage companies, because the mortgage companies were clever (i.e. greedy) they sold their mortgage debts to other banks. This enabled them to lend even more. Therefore, when subprime mortgage companies went bankrupt the whole financial system suffered from the losses.

How does the Sub Prime Crisis effect me?

If you try to borrow now, you will find it difficult and more expensive because banks are being much more cautious. Also the defaults contributed to falls in US house prices and this could lead to a recession.

What is Inflation?

Inflation is a sustained increase in prices. - Inflation means the value of money decreases.

• A simple example of inflation: The price of bread today is £1.00. 30 years ago, you could get a loaf for 9p.
  
• The inflation rate measures the annual % change in prices. In the UK and US, inflation is about 2%. (most prices are rising quite slowly)

Why Do Economists Worry so Much About inflation?

A good question. In a sense it doesn't matter if prices go up, so long as your income goes up as well. However, periods of high inflation can lead to great instability. When inflation gets out of control money loses its value and in extreme cases, people may have to resort to a barter economy. (for example Weimar Germany in 1923 )
In modern economies this is unlikely, but economists worry that inflation is a sign that the economy is growing too fast and is unsustainable. It is argued low inflation enables stronger growth in the long term. For this and other reasons governments like to target low inflation.

If you would like to ask a question on Economics feel free here:

Iraq War and US Recession

On the front page of Reddit today, was this post

"I'm no economist, but some things are obvious: To stave off recession we can leave Iraq. We can stop the irresponsible government borrowing. We can reduce military aid to dictators like Musharraf. "

Reddit


This is an examination of the Economics behind the statement.

1. Would leaving Iraq avoid Recession?

No. The Iraq war has cost the US government alot of money. It is hard to precisely calculate because the cost has not been put in the defense budget but has been squeezed through as 'supplementary spending'

Although, the Iraq war has cost a lot of money it has not caused the housing crisis or the threat of recession. (I happen to believe it was wrong to invade Iraq) but I could never claim leaving Iraq would avoid a recession.

If the US government did reduce spending on the Iraq war effort, it would not boost the economy in the US. In fact it is argued that wars can be good for economies. It creates increased demand for military hardware, creating jobs. (If you like conspiracy theories, some suggest a motivation for the continuation of Vietnam war is that many defense companies were making a very nice profit out of building so many bombs and tanks e.t.c.) Leaving Iraq would do nothing to solve the economic ills of the US economy. (although there are many other good reasons for leaving)

2. Would stopping Irresponsible Government Borrowing avoid Recession?

No, It would make it worse.

Firstly the US Government borrowing is irresponsible. There is no good reason for the US to have a national debt of $9,000 bn (65% of GDP) Alot of the debt is a result of irresponsible tax cuts for the rich by Reagan and Bush. These tax cuts did nothing to boost the long term potential of the economy. They just made the government's fiscal situation worse.

However, reducing government borrowing at this particular point in time would make the recession worse. If the government cut spending and increased taxes, it would reduce demand in the economy and lead to a further slowdown in growth.

If the government didn't have such a large deficit, they would be able to pursue a more expansionary fiscal policy which might actually help to avoid recession.

3. Reducing military aid to dictators.

If foreign aid to foreign countries was stopped, the money could be injected into the US economy; this could have a minor benefit, but as a % of GDP, the aid is relatively insignificant and would not turn around the economy.

Conclusion

In the long term the US should try to reduce its budget deficit, the US should also look very carefully at why it is spending money abroad.

But, the main reason for the US recession is the state of the housing market, whilst house prices are falling and repossessions rising, the US will find it very difficult to avoid a recession.

• Can US and UK avoid Recession?
• What went wrong with US economy
  

Fed Panics as Interest Rates Slashed

After many years of cutting interest rates by 25 basis points at a time, the Fed responded to growing stock market uncertainty by cutting interest rates by 0.75%

It is quite a bold move, although whether economic data merit such a big cut is a matter of debate. It is certainly indicative of the changing mood sweeping the US economy. Although in 2007, there were concerns over the Housing Market it was hoped that the economy might avoid a serious recession. However, with no signs of a slowdown in house prices, and worsening company profits Wall St brokers have voted with their cash - selling shares as most now predict a recession in 2008.

What effect will a 0.75% cut in rates have in 2008?

The big question is to what extent the cut in interest rates will have an impact on the economy?

• The immediate effect is that homeowners will see a fall in their mortgage payments. This will make a significant help in avoiding a growing number of mortgage defaults and house repossessions.
• Liquidity Trap? It is argued by some that cuts in interest rates may be ineffective in increasing demand; this is because confidence is already low and lower rates will not stimulate investment and consumer spending. Although their is some truth in this I do feel that a 0.75% cut will be a big help to the housing market - one of the weakest areas of the US economy

More Problems for the Dollar.

One thing the Fed have made clear with this cut in interest rates is that they are not concerned with a falling dollar (or at least it is not their highest priority). This cut in interest rates will make dollar securities even more unattractive contributing to further falls in the dollar.

Inflation?

Amidst all the talk of recession, it seems rather impolite to bring up the topic of inflation. Yet, despite the doom mongers and predictions of recession, there are signs that inflation has not been completely subdued,

1. rising commodity prices are pushing up costs.
2. The dollar's devaluation is pushing up import prices.

This cut in interest rates will increase inflationary pressures at some stage. Although it is fair to argue that inflation is the least of America's problems at the moment.

A Reward for Bad Lending?

With all the problems over bad mortgage lending, such a big cut can be seen as throwing a lifeline to many subprime mortgage dealers. It may be harsh but this rate cut might be seen by some as 'rewarding' bad lending.

Forecast for Stock Markets in 2008

Firstly, I should say I have no money to invest, so I cannot put my money where my mouth is (a trait of Economists I fear)

Nevertheless, the big falls in the stock market have made me wonder whether now would be a good time to invest.

Why is the Stock Market Falling.

The FTSE 100 fell 323 points yesterday closing at 5,578. It has now fallen 14% since the start of the year. The fall of nearly 900-points has wiped out the gains of the last 18 month.

1. Fears of US recession. Despite impressive growth in the last quarter of 2007, many talk as if recession in the US is an inevitability. The main factor is the problems in the housing market. House prices have already fallen by 5%, and are predicted to keep falling. Falling house prices will have a significant impact on reducing consumer spending (traditional the mainstay of the US economy)


2. Global Credit Crunch. Related to the crisis in the US housing market, is the problems stemming from the sub prime markets. Basically, many banking firms have had to write off huge losses, this has led to caution in further bank lending and will slow down the economy. Last week there was bad news for the bond market used for buying mortgage loans. Falling house prices and rising repossessions have reduced their value causing losses for banking firms.


3. Fears of a Global Recession. The assumption is that a US recession will lead to a global recession. US imports plays a significant role in boosting global growth. If US enters into a recession it might bring other economies down as well.

Why It Might be a Good Time To Buy

1. Share prices have already fallen in anticipation of the recession. Even if a recession occurs, there is chance that share prices can rise. (Share prices often rise in recession years, because the stock market have already built the recession into prices before it occurs.


2. A global recession is unlikley. The US is no longer the dominant force in the world economy. Economic growth in countries like China and India will take up some of the slack. I feel it is possible for the US to experience recession without dragging the UK and EU into recession as well.

Having said that, I do feel there are real problems with the US economy, the housing market may continue to fall for longer than people might hope. I also doubt that lower interest rates and expansionary fiscal policy will be able to do much to stimulate growth. The real question is how much the US economic malaise spreads to the rest of the world.

• list of companies in FTSE 100

Can US and UK Avoid Recession?

Recession is defined as a period of negative economic growth for 2 consecutive quarters. The US is heading towards recession, with many now seeing it as an inevitability; however, others feel that there are some things the government can do to try and avoid the likelihood of a recession.

1. Fiscal Policy

The government can increase AD through cutting tax rates and / or increasing government spending. Lower income taxes give consumers greater disposable income, therefore consumption and economic growth increases. Expansionary fiscal policy involves a larger budget deficit.

It is interesting to note that most Presidential candidates seem to support some kind of fiscal stimulus package, with candidates either calling for lower taxes and / or government spending.

Some evaluation of the effectiveness of fiscal policy:

• Some taxes will have more effect on increasing spending. e.g. if you cut tax for the rich spending it will only increase a little because they have a high marginal propensity to save.
• Depends on Confidence. If people are pessimistic about the future, tax cuts may not be spent but just saved see Keynes' paradox of thrift.
• Depends on National Debt. In the US, the National debt is already 65% of GDP, this reduces scope for expansionary fiscal policy because if the government borrows more it may put upward pressure on interest rates. It will also further increase future interest payments.
• Crowding out. Crowding out can occur when public sector spending reduces private sector spending. i.e. because government sell bonds to private sector, the private sector have less money to spend. Keynesians say this crowding out does not occur in a recession because resources are wasted and are not being used.

2. Monetary Policy

Expansionary monetary policy. If the monetary authorities cut interest rates it will make it cheaper to borrow and therefore, should encourage consumption and investment. In the US some are talking of the Fed cutting interest rates to 1%

However, this may conflict with targets for inflation. e.g. rising energy and food prices is leaving Central banks less room for cutting interest rates.
It may also effect the exchange rate. e.g. if US interest rates were cut it would cause a further devaluation in the dollar.

3. It depends on things beyond the control of the government.

In the US, the future of the economy depends on how the housing market responds. If house prices keep falling then lower interest rates may be insufficient to boost spending and growth in the economy. It also depends on international factors like how much demand there is from other countries.

Basically government can try but there is no guarantee it will work. Some economists even suggest recessions can be necessary. i.e. if banks are bailed out for making bad loans they will continue to make them in the future.

• Is US heading towards recession?
• Economic Recessions
• Problems in recovering from recessions
  

The Economics of Raising Children

Before the industrial revolution, children were largely seen as an economic asset. Although, they were extra mouths to feed, within 10 years children would be able to start working, either at home or in the fields. This would provide valuable income / produce for the family. The cost of raising children was low; children required no schooling, no fancy X boxes, they were an investment for a family. Having children had an economic incentive.

Another important factor about having children was that it provided the best hope for old age insurance. In an era of no government pensions and limited social welfare, who would look after you in old age? Hopefully your children. But, since death rates were quite high, children often had only a limited chance of reaching adult life and outliving their parents. Therefore parents felt it necessary to have several children to ensure there would be a at least some children who would survive to look after them in old age. This in part explains higher birth rates in developing countries.

However, in modern society the economics of bringing up children has completely changed.

Now children will be unlikely to start working before 18. And when they do start working they are unlikely to give any money to their parents.
Furthermore the cost of bringing up children has escalated with the development of consumer society.

Cost of Children

The cost of bringing up children in the US, has been documented in this study here cost of bringing up children

It is estimate that a low parent family with income of less than $40,000 will spend $124,800 on their children by the age of 18

For a family earning over $65,500 the estimated cost rises to $249,180

Furthermore, having children reduces the potential earning power of parents, especially women. The firm may pay maternity leave, but taking a break to have children leads to poorer career opportunities and less chance for promotion.

Given the economics of having children it is hardly surprising that we are witnessing a decline in birth rates. Indeed from the perspective of rational behaviour, there seems no economic incentive for having children at all. Maybe its a good job economics isn't everything after all.

This in itself could be a serious economic problem as many Western governments face a looming demographic timebomb - less workers to pay taxes, and more old people to receive pensions and health care treatment.

It is unlikely subsidies for children would alter social trends in having fewer children. With a cost of over $200,000, the subsidy would have to be pretty high to make any difference.

An easier option for government may be to actually encourage immigration, especially of young people.

What Went Wrong With the US Economy?

The US economy remains the biggest and most influential economy in the world. Yet, despite its status the US economy is experiencing unprecedented problems and the threat of a recession is only one of many problems affecting the US economy. Many of the economic problems faced by the US were largely avoidable and are the result of economic mismanagement at various levels.

Fundamental Problems of US Economy

• National Debt of $10,000 bn (68% GDP
  
• Current Account Deficit $857 billion equivalent of 6.5% of GDP [1]
• Housing Market - House prices have fallen by 30% in some areas.
  
• Rising Inequality
• Devaluing Dollar - Loss of Confidence In America and America's economy. (US Dollar Collapse?)
  
• Record Debt Levels - Past growth has been financed by consumer borrowing and
• Credit Crunch - Loss of confidence in banking system due to bad loans
  

Housing Boom and Bust

House Prices - Boom and Bust

The US Housing Market is a classic example of an avoidable asset price boom and bust. Various factors allowed house prices to rise much faster than incomes creating an asset which was fundamentally overvalued. As house prices fall to correct the imbalance, there will be a marked slowdown in consumer spending and could tip the economy into recession.

Why did the Housing Bubble Occur?

1. No regulation of Subprime mortgages. Simply put, the mortgage industry was able to sell mortgages with casual disregard for whether they could be paid back. This is a simple recipe for future mortgage defaults, home repossessions and declining house prices. In Europe, this mortgage mess would not have occurred because the mortgage industry is closely regulated to prevent this kind of mis selling. The US mortgage industry was irresponsible, but, the government are also to blame for allowing irresponsible practices to occur.
2. Low Interest Rates. In 2001 interest rates were cut to stimulate growth, with interest rates so low, people felt mortgages were affordable; wrongly assuming they would not increase. Alan Greenspan never saw the housing market as an overvalued asset bubble and thus did not nothing to prevent it.
   
3. Adjustable Mortgages. To avoid volatility in the housing market, European economies (except the UK) generally promote more fixed rate, long term mortgages. This insulates against interest rate induced volatility and helps create greater stability (although it is fair to say many European economies have experienced a booming housing market)

Trickle Down Effect and Rising Inequality

Graph showing rising inequality in the US

Since 1980 inequality in the US economy has increased. Even Alan Greenspan has admitted that rising inequality in the US "is a very disturbing trend"The fastest income growth has been focused in the highest earners Yet, income tax cuts have also been repeatedly been targeted at high income earners. In real terms the minimum wage has failed to keep up with growth in real incomes. At the same time more people have moved into part time / unskilled / low income jobs. The effect has been to create a two tier labour market. One highly paid with job security; the other low paid with little security. Although, unemployment figures are low, this hides a large amount of temporary, low paid and insecure jobs. The fundamental problem is that the government have shown little regard for effectively reducing relative poverty. It has been low on the agenda and the national debate in US has tended to ignore this problem

Further reading: inequality in the US Economy

Budget Deficit and National Debt

US National Debt - $9,007.7 2007 Bureau of the Public Debt (65% of GDP)

It doesn't take a genius to work out that if you cut taxes for the rich and increase spending, you will get an increase in the government deficit. But, with the exception of the Clinton administration, recent American Presidents have casually disregarded any aspiration for fiscal responsibility. Despite a looming demographic problem, the Bush's and Reagan have allowed the size of the budget deficit to increase. This budge deficit puts upward pressure on interest rates, increases consumption at the expense of private sector investment and means future generations will be forced to pay back a higher interest payments. The National debt is even worse when the governments liabilities for public sector pensions are included. Furthermore, the ageing population will aggravate the national debt in the future. An ageing population places higher demand on health care and pensions, and pays less tax.

The deficit was created with little long term benefit. The deficit has not been used to stimulate demand in a recession, it has not been used to invest in public services. When Bush, cut taxes for high income earners in 2001, it was a badly targeted expansionary fiscal policy - it did nothing to increase the long term productive capacity of the economy. The increased spending on military hardware benefits the economy little save a small group of defence companies.

The problem is that now the US economy faces a real recession, there is little scope for expansionary fiscal policy. The next President will face real difficulties in reducing the national debt because demographics will work against fiscal stability and the deficit will worsen because of the stage of the economic cycle. One of the most damaging economic legacy of the Bush era is a burgeoning national debt with little hope of fixing it. This will be a constraint to future growth. The national debt will require either higher taxes and lower spending, or it will put upward pressure on interest rates crowding out private sector spending.

Current Account Deficit

The US Current Account deficit stands at over 5% of GDP (down from 6.5% in 2006). It is true in an era of capital mobility a current account deficit is easier to finance. But, if you maintain a deficit of over 5% for a prolonged period of time, it is unsurprising if, eventually, you face difficulties in attracting the necessary capital flows. Because Asian investors are becoming more cautious over the prospects in the US deficit, capital flows are slowing down contributing to the devaluing dollar. The current account deficit shows that there is a fundamental imbalance between consumption and domestic production and could act as a contstraint on future growth.

Devaluation of Dollar.

The Long term decline in the dollar

The recent devaluations of the dollar partly reflects changes in the trade cycle; i.e worsening prospects of growth and falling interest rates make it less attractive to buy dollar assets. But,in addition to short term factors, the falling dollar is also symptomatic of the structural weaknesses in the US economy. It is becoming less competitive compared to its trading partners.

Confidence in America and the Dollar

Because the US economy is weakening, the dollar no longer seems so attractive. The financial losses resulting from the subprime crisis even raise the riskiness of any US assets. Because the US is the strongest economy it seems inconceivable that the US could default on its loans. But, some believe it is now at risk of defaulting.

Further Reading

• Boom and Bust in US Housing Market
• Reasons for Fall in US Dollar
• Debt in US
• Essays on Recession
  

Sources

[1] Current Account deficit 2006 Economist (Since 2006, the current account deficit has decreased to 5.5%

• US External Debt as a % of GDP
• Federal Debt at Treasury Direct

Image Sources:

• US House Prices
• Long Term Dollar
  
• Current account deficit
• Inequality - Federal Reserve Bank of San Francisco
  

US Presidential Canditates on Economics

It is no surprise that the US economy is heading towards recession - when you look at the Economic suggestions from our Democratic and Republican presidential hopefuls you really want to keep selling those dollars.

The best choice seems to be John McCain who at least admits

“The issue of economics is not something I’ve understood as well as I should,” he says.
“I’ve got Greenspan’s book.”

Of course whether having a book by Greenspan will do anything to illumine his economic ignorance is rather a mute point. (Greenspan on Housing Market - Well, it's doing quite strong, but its mainly economic fundamentals, so there's no harm in cutting interest rates even further...)

It's good to see there is a presidential candidate flying the flag for irrational stupidity. This time it is Rudy Giuliani who says that the solution for all America's ills is just a permanent tax cut (presumable for the rich as they usually are in America). Giuliani lays claim to the belief that any permanent tax cut will of course pay for itself.

Alas why did Reagan's tax cuts leave a budget deficit of 5% GDP, and why have Bush's tax cuts created a similar mess? But, of course if we try cutting taxes again - it's bound to work this time!
If only Economics and Politics were so simple:

Tax cuts! - Increase Productivity! increased Demand!, Increase Growth! Budget Surplus!

Why do people associate the Republican party with economic competence when they hold onto such wildly optimistic drivel. There is no empirical evidence tax cuts 'pay for themselves' there is no empirical evidence that cutting taxes increase incentives to work (maybe when they are very high e.g. 60% income tax) But American income taxes are already quite low.
Are American voters so stupid that they fall for it everytime? Tax cuts for the rich is alas not a panacea for all economic ills.

It is hard to find anything else in the Republican party worth mentioning. There mantra seems to be low taxes - Pro business environment and the usual platitudes.

I would be interested in hearing how Republican candidates would deal with the National Debt and budget deficit. (The structural deficit will start deteriorating soon because of demographic factors and ageing population.)

If I can find anything sensible by the Democrat candidates I may mention it next time.

Thanks to Paul Krugman's article for condensing the candidate's ideas

Forecast for Chinese Yuan

Officially the Chinese do not believe in revaluaing the Yuan, amongst other things, the political leadership seem hesitant to appear giving in to US demands. But, in practice and unofficially, the Yuan is steadily but surely appreciating in value.

Furthermore, despite recent appreciation's approaching 20% in value since 2005, there are very good reasons to expect the Yuan to keep rising in 2008 and probably beyond.

The reason for the forecasted rise in the Yuan includes several factors.

Inflationary Pressures in Chinese Economy.

The Chinese monetary (and political) authorities are increasingly worried about overheating in the Chinese economy. With economic growth close to 10% it is hardly surprising that inflation has started to creep up, reaching 6.9% last year. An appreciating exchange rate is an effective method to slow down growth. It makes exports more expensive and reduces demand in the export sector.

Chinese Trade Surplus.

Despite modest rises in the exchange rate, there has been no reduction in the size of the trade deficit. With all this surplus foreign country it is increasingly difficult to keep the exchange rate down. In the past the Chinese bought large amounts of dollar securities. They are still doing this, but with US interest rates falling and Chinese interest rates rising, it is becoming less attractive. Also the weakness of the dollar is discouraging a further build up in US Assets.

Last year the US current account surplus rose from 4% of GDP in 2004 to 11% of GDP. Although a trade surplus is not directly related to currency valuations, it nevertheless is a reflection of the imbalances in the Chinese economy, which could be reduced by a revaluation.


Dollar to Yuan Exchange Rate Forecast

When the Dollar / Yuan peg was dropped the Yuan stood at 8.26 to the Dollar.
In the beginning of 2008 it has fallen to 7.27

• Stephen Green, head of research in China for Standard Chartered, predicts the Yuan will rise further to 6.17 by the start of 2009.

Whilst other investment firms share this bullish outlook for the Yuan, it remains to be seen how much the Chinese government will be willing to alter its stance to the currency. despite concerns about inflation, it is still perhaps more concerned about unemployment and inequality. It holds a deeply cherished belief that an undervalued Yuan is essential for a strong economy.

Whilst, a revaluation of the Yuan may help both China and the rest of the world in dealing with surplus, there is still no guarantee it will occur.

One thing is very likely - in the long term the Yuan will continue its remorseless upward appreciation. - Expect more Chinese students wishing to take advantage of UK and US education

Sources:

• Chinese Yuan at Telegraph
• Chinese Yuan at Economist
  
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The decline of the Corner Shop and Small Firms

An enduring memory from childhood, is walking down my Grandmother's street (in Morecambe) to the corner shop at the end of the road. Here we would buy the odd convenience item; the shopkeeper was a cheery fellow, and despite the size of the shop they seemed to always sell what we needed. 20 years later, it is no surprise that the small corner shop has been converted into luxury flats. In fact it barely seems credible that a small food shop could have ever existed on such an insignificant road.

The decline of small independent retailers has been well documented. It is something everyone seems to regret, even if we ourselves, rarely go to these small independent retailers. Walking down Mill Road in Cambridge last week, I saw many poster campaigning against another Tesco being built. It is perhaps fashionable to criticise big supermarkets and I can understand why. However, whilst it may be fashionable to criticise Tesco's there seems to be no shortage of shoppers willing to go and buy all their groceries and more.

Reasons for the Decline in Independent Shops

• Higher Prices. Small shops cannot benefit from the same economies of scale of big shops. Their wholesale price is higher, therefore even with a smaller profit margin they may end up with higher prices. It is hardly surprising that consumers go to the cheapest place to buy goods.

• Time. The main advantage of the large supermarket is the convenience. Rather than having to go to several shops and queue up at the till 7 times you can buy all your goods in one place and only have to pay once. This can save significant time on your shopping. If the average hourly wage is £15 an hour, it is likely that this advantage is even more important than the relatively small time difference

• Internet. I am the worst offender at this. I buy upto 50% of my consumption online. Quite often I will pay a £5 delivery charge just to get groceries delivered, the main advantage is the time saving and the convenience of choosing items online.

Factors Favouring Small Independent Shops

1. Different. Some local shops offer services and goods that are just not available from big supermarkets.
2. Atmosphere. Small independent shops can have a unique character and feeling that is lacking in bigger department stores and supermarkets. Supermarkets tend to use the same marketing devices and design
3. Quality of Service. Small independent shops can give a more personalised service. You don't feel like you are a small pawn in the workings of a vast multinational.
4. Coolness. Tesco just isn't cool any more. But, supporting your local fishmonger, grocer is.
   

I wrote this because I happened to walk into a small independent shop in Oxford, just off Cornmarket street today. It is something I very rarely do, but, I had an interesting conversation with the shop owner.

I don't feel guilty about shopping online. But, do sincerely hope the local independent store is able to make a comeback (or at least stop the decline)

• Advantages and Disadvantages of Tescos
• Tesco Profit Grow Amidst Competition Enquiry
  

Economics of Global Warming

Global warming has become one of the most pressing issues of modern society. Once dismissed as the ravings of a fringe movement, people are increasingly realising that global warming is something that cannot be ignored. In particular the economic effects of global warming are very significant.

Economics Problems of Global Warming

1. Rising Food Prices. Global warming is causing desertification of agricultural land. This is compounded by a shortage of water. This will cause problems in supplying food leading to rising prices. This will particularly affect countries which are net importers of food.
2. Rising Sea Levels. Global warming is causing sea levels to rise. This will cause structural damage and loss of land. To fight rising sea levels is expensive in terms of flood defences. But, also even the best flood defences may not be able to prevent rising sea levels.
3. Storm Damage. It seems that global warming is leading to an increased propensity for flooding and storms. This has led to huge insurance payouts. In 2007, the floods in the UK could be due to global warming. This will lead to higher insurance premiums. - Some areas may become uninsurable.
4. Loss of Wildlife. Changing temperatures can cause havoc for wildlife. The economic cost may be hard to evaluate, but, if species go extinct it may prevent future medicines being invented.
5. Migration. Global warming will cause migration from some countries to others. Those that suffer the most from global warming will see depopulation. There will be overcrowding in the other countries
   

Advantages of Global Warming

1. Improved Agricultural Output. It is argued that higher temperatures may lead to increased food production in some countries. This conflicts with the issue of desertification. - Some areas will have increased production, some areas lower production
2. Lower Heating Bills for Cold Countries. - But higher air conditioning costs for warm countries.
3. The rise in Temperatures is only temporary. Some argue that world temperatures have always fluctuated and these rise in temperatures will only be temporary.

links

• Is global warming happening in the UK?
• Global Warming at Geography online
• Economics and Global Warming

Simple Ways to Cut Your Bills

It might be surprising how easy it is to cut your bills. Often what we are paying for is unnecessary; using these tips will help to reduce your bills, without effecting your quality of life

Keeping Changing to the Cheapest

With rising gas and electricity prices it is more important than ever to find the cheapest supplier. The best piece of advice is to check different price online at a price comparison site. It is best to do this at least once a year. Most energy companies rely on customer inertia; this means people feel it is too much hassle to switch accounts, therefore they remain on the existing deal. If you take the effort to look around for cheaper deals, you will be rewarded with comparatively cheaper prices. The process is relatively painless - it is definitely worth the effort.

Be Less Reliant on Heating and Air Conditioner.

Whenever I visit America, I am always amazed at how aggressive air conditioning is used. You can go into some buildings and it is really cold. I have to take a jumper to put on when I go inside the building! It is not necessary to have so much air conditioning, to reduce the temperature by such a large amount costs a lot. If you change the temperature you can save money without becoming uncomfortably hot. Also, it is quite extravagant and expensive if you leave the air conditioner on all day, just so it will be not too hot when you arrive.

Keep a checklist of dates for Bill Renewal.

One thing I find difficult is to remember when my bill contracts run out. By keeping a list of dates it makes it easier to prepare in advance for searching for new quotes. As a general rule, I will always recheck any annual insurance / mortgage / contract. Because invariably switching to a new supplier offers a cheaper deal - usually taking advantage of an introductory offer.

Investing in Best Equipment

Sometimes to save money we need to invest money. Making the switch to energy efficient lightbulbs will soon pay for itself. But, look around for the best price, there are often special discounts in certain shops - there prices can vary significantly.

Combined Telephone / Internet accounts.

I was paying £16 a month for my cable TV, on ringing my internet provider (BT) I found that they would give free cable TV because I was already paying for internet. This is a good example of how ringing your existing suppliers often enables you to take advantage of the latest special offers and good deals.

Don't Pay for What You don't use.

Because my car is not particularly valuable, I decided to get only 3rd party insurance. Although this is a risk, I was paying a hefty premium for comprehensive insurance; it didn't seem to offer good value for what I was getting. Similarly, I recently can celled a mobile subscription because there were quite a few months in the year where I never used the phone - pay as you go proved better value in the long term.

Predicting Inflation and Exchange Rates

Predicting inflation is a very important task for Economists. Future forecasts of inflation are used to determine current monetary policy. If inflation predictions are wrong it can cause inappropriate monetary policy, resulting in either inflation or recession. Although economists may look at various economic data, there is no foolproof method for predicting inflation. Generally speaking inflation is easier to predict and less volatile when inflation rates are low. As inflation increases it also becomes more volatile and harder to predict.

• Essay on Predicting Inflation

Predicting Exchange Rates

Predicting exchange rates is even more difficult as speculation and market sentiments play a greater role in determining equilibrium prices. Exchange Rates are very important for exporters and economies reliant on trade. Many investors seek to make a living through predicting future exchange rate fluctuations. Apart from the role of speculation, the most significant factor is interest rates and economic growth.

• Predicting Exchange Rates.

Related Essays

• UK Inflation forecasts 2008
• Sticky Inflation forecast for UK
• Exchange Rate Predictions

The Economics of Fear

In altruism and behavioural economics, we took a very basic look at why the assumptions of traditional economics are insufficient for decision making. Another important factor in behavioural economics is the issue of fear. There are many examples of how this issue can influence economic decision making.

Insurance.

People are willing to pay a significant amount to prevent a small chance of losing a large amount of wealth. In the long run, insurance is more expensive than the benefits that accrue, but, people prefer the security of knowing they won't lose everything. However, with insurance there is also the issue of decreasing marginal utility of wealth. We don't miss the extra £50 a month insurance payment, but, we could not cope with losing our house.

Hysteresis.

This is an idea that people are influenced by events in the past. Even if circumstances have changed, people remember what it was like in the past and this remains a powerful influence over current economic decision making. For example, after a period of economic properity, people may keep spending in the sales, even though their future income prospects are less promising. Expectations of inflation are very much based on past data. High inflation begets more high inflation.

Influenced by Outside Influences.

Consumers are very much influenced by outside media pressures and perceptions of economic reality. For example, an interesing phenomena is how many Americans think America is already in a recession. The American economy is not a recession (even if house prices are falling and there is a credit crunch) Yet, people will talk as if there already is a recession. This fear of a recession can of course make a recession a reality. If people think they are in a recession, their spending will fall (even though their income may be rising) this will lead to lower aggregate demand and lower economic growth. The important thing is that people's spending is influenced not by their own income, but, perceptions of the general economic outlook.

A good example of this is the run on the bank syndrome. When people heard Northern Rock was in difficulty, people rushed to the bank to withdraw their savings. Because other people were rushing to the bank, many people felt they ought to. This was despite the fact that Northern Rock's problems did not affect savers directly. It was due to problems of refinancing mortgage loans. But, in this kind of situation there is often a 'herd' mentality - people follow what others are doing.

Bounded Rationality

Another issue is that people may be bound by limited information. Therefore, it is not so much fear as inadequate information which leads to irrational decision making. For example, how many American consumers would know the inflation rate and economic growth rate of the American economy.

Booms and Busts

Markets with supposed 'perfect information' are often subject to wild fluctuations. In periods of booms people jump on the bandwagon - buying share or houses. But, when market sentiment changes a little, the mood can swiftly change as people frantically sell, trying to get out before the market collapses. There are many examples of prices moving independently of economic fundamentals e.g. dot com bubble and bust of early 2000s.

Unemployment Benefits and Costs

Back in the early 1990s, as the economy plunged into recession, the then Chancellor of the Exchequer, Norman Lamont said in the House of Commons - 'Unemployment is a price worth paying for lower inflation.' It was a similar sentiment shared by Mrs Thatcher in the 1981 recession. Yes, her policies were causing unemployment, but, she would claim it was an inevitable price for dealing with the inherited inflation. 365 economists wrote to the Times claiming her policies were flawed, but, the Iron Lady was not for turning. Unemployment stayed close to 3 million until 1986.

But, in this recession, as unemployment continues its remorseless rise towards 3 million, there is a general consensus that this is a heavy price to pay for a credit boom and bust.

A good A Level economics question is - Discuss Policies to reduce Unemployment (15). The answer would be a mixture of supply side policies and demand side policies. But, the truth is that currently there isn't really anything the government can do to prevent unemployment rising towards 3 million. We have cut taxes, increased spending and lowered interest rates. We have even experienced a depreciation in the Pound, all of which in theory boosts demand.
In short there is nothing left. The government would not dare to borrow more in 2009, we've just about had our limit of fiscal expansion. Interest rates have fallen sharply and could fall to 0% this year. However, the depth of the downturn means the usual policies just aren't working. At best there will be a long time lag before growth restarts. One thing is for sure, the first sign of growth will be greeted with relief by many.

To go back to the first statement the costs of unemployment are very obvious and pressing. But, it takes a real leap of the imagination to start seeing it in terms of benefits as Norman Lamont tried back in 1991.

How Much Does the Government Spend ?

Think of a very high number, double it, and then add a few zeros.

In the UK, the government is forecast to spend in 2007-8 £557,400m or £557billion. (over 40% of GDP)

In the US, the government is forecast to spend £5,081 billion or 34% of GDP


For a break down of government spending in the UK, I updated a table with a few of the different departments. The biggest department, by far, is social security, which includes the different types of benefits - the backbone of the welfare state. The second biggest is health care

What % is spent on defence?

• In the UK, only 2.5% or £32 billion. of GDP is spent on defence. This is the lowest % for a long time.
• The US. spent £439 billion on military spending in 2007. This accounts for nearly 45% of total global military spending. However, as a % of GDP, it is not as high as some might imagine. It is 3.7%. Higher than most European countries such as France (2.5%) and UK. But lower than countries such as Saudi Arabia (10%)
• In comparison, in 1983 during the cold war, military spending in the US was 6.1%
• However, statistics can lie. The Wars in Afghanistan and Iraq have largely been funded with supplementary spending not included in these figures. The US also has a black budget for military spending which is not included in these figures. For example, nuclear spending and pensions for war veterans is not included.
  

• Different types of government spending

Sources

• UK Government Spending
  
• US government spending
• Military Budget of the US
  

Difference Between Wealth, Income and Assets

Wealth and income are quite different and should not be used interchangeably.

• Wealth is known as a stock,
• Income is a flow.

What this means is that wealth can be measured at a particular point in time. It is the accumulation of all your assets, both physical and financial investments. If sold these assets could be turned into money.

Your wealth might comprise

• house: £100,000
• Shares and Bonds £30,000
• Cash in the Bank £10,000
• Other assets such as car £5,000

Total wealth £145,000

Definition Of Income

Income is the amount of money your receive per week, per month or per year. For example, the income of the Prime Minister is about £75,000 per year (excluding all those private directorships). His wealth may be £500,000

See also:

• Distribution of Income and Wealth
• Policies to Reduce Poverty
  

Why Have Crime Rates increased despite Economics Prosperity

Here is a paradox – Why have Crime Rates increased, despite better living standards in the West?

In the past 80 years, we have witnessed unparalleled improvements in GDP per capita. Average living standards have increased. Furthermore the incomes of even the poorest have increased in real terms. Government benefits have ensured that no one in the UK or US live in absolute poverty. This was not the case pre 1939. Why then, despite increases in material prosperity have crime rates also increased at unprecedented rate.

1. There is More to Steal.

In the Great Depression of the 1930s there wasn’t much to steal. There was no mobile phone theft, motor cars were a rarity, if you broke into your neighbours house, chances are you wouldn’t find anything particularly worth stealing. There were no videos, computers, tv’s e.t.c. Nowadays, there is so much more material goods, there is always a constant temptation.

2. Markets to Sell.

A lot of crime is steal to order. If you have an easy way to sell goods it makes crime more profitable. E.g. ebay makes it easier to dispose of stolen goods. However, ebay is a relatively recent phenomenon.

3. Relative Poverty

It is true that the incomes of the poorest have increased. However, relative poverty has not necessarily fallen. Relative poverty is the difference between the highest earners and the lowest earners. Whilst there is a yearning gap between the poorest and highest earners, it could be said there is a motivation for people to steal. However, it is worth remembering that criminals are not necessarily the poorest in society.

4. Laxer Prison Sentences.

It is debatable that prison sentences are significantly more lenient. Nor are prison conditions much better than they were in the past. Prison is as much a deterrent as it ever was.

5. Changing Moral Standards.

This goes far beyond the remit of an economist. But, it could be argued that people have less compulsion about stealing than in the past. It is hard to say, but I don’t think there was a golden age, when everyone was a saint.

6. Unemployment

Another argument is that there are higher levels of unemployment in this age, but, it was much higher in the Great Depression of the 1930s.

7. Increased levels of Alcohol and drug abuse

Drug activity accounts for a significant aspect of crime rates in the Western world. True, drug misuse occured before the war. But, arguably it has got worse in recent decades

Related

• Does economic growth increase happiness?