Forecasts for US Economy

Readers Question: A Few years back when US cut interest rates drastically to recover the economy from dot com bust, it leads to a boom in the housing market and created another bust. Currently US has cut the interest rates again drastically to 1%, wouldn’t it create another boom and bust? Thank you.

Graph of US Interest Rates


It is a very good question.

Firstly, you are right that the cut in interest rates did facilitate a boom in house prices in the period 2002-2006. This boom in house prices came to an end in 2006, and as house prices fell in 2007-08, the negative wealth effect pushed the economy into recession.

Boom and Bust 2001-08

• The dotcom bubble burst in 2000-01, also the events of 9/11 left the US facing a serious downturn.
• The Fed acted decisively to cut interest rates to 1%. This helped the economy avoid a serious downturn and the economy soon recovered. Many praised Alan Greenspan for his decisive action to avert recession, during a real crisis for America.
• However, look how long interest rates were kept at 1% - until the end of 2004.
• Because interest rates were so low. Buying a house was really attractive. Rising house prices and interest rates of 1%, encouraged US mortgage companies to offer a mortgage to every Tom, Dick and Harry. (better known as subprime mortgages).
• Rising House Prices also caused a boom in new house builds.
• However, by 2005, the Fed started to respond to rising inflation and a booming economy. Interest rates were increased to 5.5% by 2006. (See: Boom and Bust in US Housing Market)
  
• This increase in interest rates meant that many who took out mortgages at 1% couldn't pay the mortgage back. They defaulted causing losses to the bank, and the financial crisis we see today.

Will A Boom and Bust Happen Again?

Now we have seen interest rates cut back to 1%, could we be in for another rollercoaster? - another boom and bust?

• It could happen. People soon forget busts. Boom and busts occur with a certain regularity.
  
• Behavioural economists note how often people engage in herding behaviour. (if asset prices are going up, everyone jumps on bandwagon. When asset prices fall, everyone sells)
• You could argue that the financial bailout of the banks encourages moral hazard. i.e. the banks have lost billions but, they can rely on the taxpayer to bail them out.

Why It Might Not Happen

• The boom in house prices was not just caused by low interest rates. It was also caused by irresponsible lending by subprime mortgage companies. I cannot see this kind of mortgage lending returning for the foreseeable future. One assumes the US has instigated better legislation for checking the suitability of mortgage lending.
• Low Interest rates are not encouraging spending. The economic downturn is so serious, US consumer spending fell at an annual rate of 3%. This is a serious decline. Even in the recession of 2001, consumer spending didn't fall. The US, like Japan in the 90s, could see a liquidity trap - where lower interest rates fail to encourage people to spend.
• The pain of falling house prices will take a long time to be removed from national psyche.
  
• The problem was not that interest rates were cut to 1%. The problem is that they stayed at 1% for too long. Of course, it is easy in hindsight to say this. But, the Federal Reserve and Bank of England will need to be more careful in avoiding the same mistake. Also, the Federal Reserve and Bank of England need to give greater weighting to asset prices and not just focus on inflation.

Boom and Busts are inevitable in some form. However, there are definite lessons we can learn from the past decade which will help minimise the risk of future booms and busts. At the moment, the economic downturn is so serious, the idea of economic boom seems hard to grasp. But, when the economy recovers in 2009 and 2010, it is essential that policy makers learn from the mistakes of the past decade. This is not just for monetary policy but also regulation of the financial system.

• What Went Wrong With US Economy

The Case for Lower Interest Rates

With US interest rates being cut to 1%, many are asking how low UK interest rates could go. Looking at the economic statistics, there is an overwhelming case for lower rates. These are some of the factors the MPC will be looking at when considering rate cuts.

1. Inflation forecast to Fall.

• Lower oil and petrol prices will reduce the cost push inflation factors that have caused current inflation to be high. The recession will cause a big fall in demand pull inflation factors as firms cut prices to retain custom.
• Wage restraint. The UK Labour market is increasingly flexible and wage restraint has meant real wages have shown their slowest growth for a while.
• Inflation expectations have fallen. The current inflation of 5% has not cause inflation to become ingrained in people's expectations. Lower inflation expectations make low inflation more likely. The below graph shows people's expectations of inflation have fallen.

2. Business Confidence has evaporated

Business confidence has fallen throughout the year. The levels of business pessimism are at very high levels. From Jan to Oct, business pessimism has fallen from -16 to -60

This pessimism is reflected in levels of employment which are falling sharply. Some point out that the rise in unemployment is being masked by many eastern European workers leaving the economy and returning to Poland / Czech e.t.c.

3. Credit Crunch Affecting Business.

We have heard a lot about the credit crunch making mortgages more expensive and difficult to get. But, the lack of lending is now starting to constrain business investment decisions. This will affect growth in the next 12-24 months. Business investment relies on borrowing from banks. But, the state of banks means they are reluctant to lend. Lower rates, will facilitate normal borrowing.

4. Falling House Prices.

Falling House prices creates a powerful negative wealth effect reducing consumer spending and economic growth. The government is increasingly concerned about negative equity which is a real problem in a period of rising home repossessions. See: problems of UK Housing Market

5. Official recession and Rising Unemployment

The economic slowdown has been remarkably swift, as this graph shows

Unemployment often lags behind an economic slowdown, but, it is rising fast

Is A Strong Dollar Good For US Economy?

One of the curious features of the last couple of months is the unexpected strength of the US Dollar against a basket of currencies. This includes the currencies of emerging economies, but the dollar has also been strong against currencies such as the Euro, Pound Sterling, Canadian Dollar and the Australian Dollar. The reasons for the dollar's rise are briefly

• Lack of confidence in other countries.
• Economic slowdown has spread from US to Eurozone area - leading to lower European interest rates.
• Financial crisis has spread to other emerging economies. Investors are even more nervous about these economies than the US financial system.
  
• There has been a strong demand for dollar as hedge funds have been withdrawing their capital from oversees market, and putting it into the relative 'security' of the dollar.

With US interest rates cut to 1% yesterday, the strength of the dollar is likely to prove temporary. Indeed many commentators suggest with an increase in the US Money supply, to finance a growing national debt, the dollar looks like a bubble ready to burst.

Nevertheless this is the Impact of A Strong Dollar on Global Economy

• US exports become more expensive. With a global slowdown, US exporters are likely to experience very difficult conditions pushing economy further into recession.
• Makes Imports cheaper. Imports to America play an important role in the global economy. A stronger dollar increases the purchasing power of American consumers and leads to higher exports. However, cheaper imports may not be sufficient to boost spending. With confidence at an all time low, American consumers are more likely to try and boost their saving rates, rather than buy more imports.
• Strong Dollar will worsen the US Current Account. At around 5%, this will mean the US will need to attract more capital inflows to finance its trade deficit. However, with US interest rates at 1%, and the credit worthiness of the US being openly questioned, it is going to be difficult for the US to attract any more capital flows. This is another reason why the dollar's strength appears rather illusory.
• Good for Global exporters to US. UK firms who export to US may benefit from strong dollar, but, the exchange rate benefits may be outweighed by the global downturn.

Normally, a strong exchange rate reflects a strong economy. If the economy is in good shape - high growth, low current account deficit, low borrowing, an economy can deal with a strong exchange rate and prosper.

However, given the perilous nature of the US economic situation, the strong dollar doesn't really help them at all. The Strong dollar reflects a misplaced hope that the dollar offers security in the credit crunch. But, with the fundamental problems in US, the strong dollar will only worsen the US Economic downturn.

Problems with Housing Market

The Bank of England has warned that 1 in 10 householders (1.2 million) face the prospect of negative equity (house value is less than the outstanding mortgage debt). As house prices fall in 2009, the number facing negative equity will increase.

Why Negative Equity Has Occured.

• Falling House prices House prices have fallen 15% on their mid 2007 peak. House prices are falling because:

1. Shortage of available mortgages due to credit crunch.
2. Poor affordability ratio of house prices to incomes is still high (above long term trend)
3. Lack of Confidence in housing market. No one wants to buy when house prices are falling
4. Impending recession and rising unemployment discourage people buying
5. Interest rates although low by historical standards, increased between 2005-07 making mortgages more expensive.
   

• Small Deposits In 2006-07, many were buying houses with small deposits. This makes it easier to slip into negative equity. For example, if you bought a house for £100,000 and only put down a deposit of 5% (£5,000) It only takes a 6% fall in house prices to cause negative equity.

How Bad is Negative Equity?

• Negative equity is not a problem if you are happy to live in the house and don't have to sell. Negative equity might not be a problem if you want to sell and move to a smaller house.
• Negative equity means it is much more difficult to remortgage. The fall in house prices creates a negative wealth effect and lowers consumer confidence. This reduces consumer spending and is a factor causing the current recession. - See: effects of lower house prices.
  
• Negative equity is a real problem if you fall into mortgage arrears and the home is repossessed. This means that even after selling the house, you will still owe money.
• Unfortunately, repossessions in the UK are rising at the moment. Repossessions in the last quarter increased to over 11,000 in the last quarter. This is a 70% increase on this time last year.
• It is worth pointing out that the ratio of home repossessions is still relatively low (about 0.4% of all loans). This is lower than the rate of repossessions in the last boom (peaking at 75,000 or 0.77% of loans. (Mortgage default rates in UK) Nevertheless, home repossession is one of the most stressful financial experiences. With unemployment rising, repossessions are forecast to rise in the near future.

Prospects for UK Housing Market in 2009

There are tentative signs of slight easing in interbank lending following the government's bailout for the banks. However, there is going to be no quick return to the lax lending criteria of the 2000s. Mortgage lending will remain constrained next year.
With a shortage of mortgage and rising unemployment demand for houses will remain muted. Futhermore no one wants to buy in a period of falling house prices.

Any Good News for Housing Market?

The best news for the housing market is the recent cut in interest rates from 5.0% to 4.5%. We can also expect future interest rate cuts to under 3%. Lower interest rates will make mortgages more affordable and avoid some repossessions.

However, lower rates are unlikely cause a quick stabilisation in house prices. Market fundamentals are likely to push house prices lower, despite cheaper mortgages.
Also even lower rates may be insufficient to avoid a rise in repossessions as the rate of unemployment rises sharply

Problems Facing Emerging Economies

A feature of the current financial crisis is how hard it has hit supposedly 'strong / safe economies' like the US, UK, Europe e.t.c. However, now attention is switching to emerging economies and the potential problems they are facing.

Problems Facing Emerging Economies.

Large Current Account deficits.

Iceland had a current account deficit of 7% of GDP. South Africa has a current account deficit of 7.7%. Basically, this means they are importing more goods and services than exporting. To finance this current account deficit, it is necessary to attract capital inflows (either hot money flows or long term capital investment e.g. Foreign firms investing in India.)

The problem is that the credit crunch has made it more difficult to attract sufficient capital flows. Even Russia, which has a current account surplus requires capital flows, but, they are now struggling to attract sufficient funds.

If a country cannot finance its current account deficit. A depreciation becomes almost inevitable. This was one reason for the depreciation of the Icelandic Krona. It is why the South African Rand and Hungarian Florint are depreciating.

Depreciating Exchange Rates

A depreciation in the exchange rate does make exports cheaper. But, it also makes imports more expensive and the repayment of foreign debt more difficult. When a currency depreciates, a country struggles to repay its external debt and therefore investors lose confidence in the economy causing a further depreciation. - It is a vicious circle. Also a depreciation in one currency can have an endemic effect on nearby economies. E.g. depreciation in Thai Bhat in 1998 precipitated a wave of falling currencies it become known as the Asian Crisis of 1998. The concern is that a depreciating Hungarian Florint could spark a wave of speculative selling for nearby Eastern European currencies.

Confidence.

In economics we keep coming back to this issue of confidence. In the financial sector, confidence is everything. The problem is that as emerging economies face difficulties investors give bad credit ratings to these economies. Because there is a deterioration in the credit worthiness of the economies, they are forced to increase interest rates to

• Protect their currency
• Encourage people to buy their now 'risky' government bonds.

Hungary recently had to increase interest rates 3% to 11%. Higher interest rates are very damaging for the economy causing lower growth. (Just imagine if the UK had to increase interest rates 3% at the moment?)

Borrowing.

Many Hungarians took out loans and mortgages in Swiss Francs. This seemed attractive because Swiss interest rates were lower. However, now the Hungarian Florint is depreciating, loan repayments are increasingly drastically.

Government Borrowing

High levels of government borrowing mean interest rates may need to be higher. It is also a particular problem if the government finances its debt by selling to other countries.

Basically, emerging economies have many similar problems to UK and US, they have borrowed too much and overextended themselves. The problem they face is that there governments may have less resources to intervene and guarantee the banking system. It may require concerted international action to intervene.

• Financial Crisis explained
  
• A New Set of Financial skittles ready to fall - Anatole Kaletsky at Times
• How Emerging economies are suffering at Economist

Why Pound Sterling is falling

Source: ONS

• This graph of economic growth shows how quickly the UK economy has deteriorated. It explains why the MPC cut interest rates by 0.5%. It also explains why many are calling for future interest rates cuts. Some forecast interest rates could fall to as low as 1%.
  
• With UK interest rates forecast to fall significantly, the value of the Pound since the summer has fallen by nearly 25% against the dollar.
  
• Lower UK interest rates mean it is less attractive to save in the UK, reducing demand for Pound Sterling
  
• Another reason for the strength of the dollar against the Pound, is the growing uncertainty of emerging economies. Hedge funds and investment trusts have been selling their investments. Since most of these hedge funds and investment trusts are based in dollars, there has been a rise in demand for dollars. This explains some of the recent strength in the dollar.

Video on Pound Sterling

• How much should interest rates fall?
• Understanding exchange rates

Should We Blame Bank of England for Recession?

Since the Bank of England was made independent in 1997, there has been a general consensus that they did a good job in preventing boom and bust and promoting the longest period of economic expansion on record. (1992-2008) Gordon Brown rarely missed an opportunity to offer himself self-congratulations on giving the Bank independence and therefore, avoiding the boom and bust, which characterised the post war British economy (See: Lawson Boom) However, the speed at which the UK has entered recession this year have left many re-evaluating the performance of the Bank.

Positive Aspects of the Bank's Record

• We did have 16 years of positive economic growth. (compared to two recessions in the space of 10 years 1981 and 1991).
• The Bank did avoid an inflationary boom. Inflation only increased above target this year, and that was due to cost push factors beyond the Bank's control.
• The recession has been caused not so much by UK monetary policy, but, the subprime mortgage crisis, originating in the US.

Nevertheless, UK policy has arguably failings.

1. Problem of Inflation Targeting. The Bank of England have one target - low inflation.- CPI of 2% +/- 1. The problem with targeting just inflation is that the Bank have a duty to place much less emphasis on:

• Slowing growth
• Booming housing markets and assets

For example, 2008, has presented the Bank of England with a dilemma - because of cost push factors (rising oil prices) we had a rise in inflation and lower growth. Because inflation rose above target, the Bank didn't want to cut rates (until this October). As David Blanchflower, a member of the MPC, argued, this meant interest rates were too high for too long. Meaning that the recession will be deeper. If the Bank had a target of low inflation and high growth, they may have had greater confidence to cut rates sooner and help avoid recession.

Should the MPC have prevented Booming house prices?

The other aspect is that maybe the MPC should have used interest rates to reduce the growth in house prices. If a boom in house prices had been avoided, the slump would have been less severe.

However, I am not convinced they should have used interest rates to target house prices. The boom and bust in house prices was due to:

• Shortage of supply, squeezing prices higher then lower
• Mortgage lending. Once very generous then completely seized up.

To avoid boom and bust in the housing market, we need policys specifically for housing market, rather than relying on macro instruments.

What Should Happen Now?

There is a good argument the MPC should give greater flexibility in targeting macro economic objectives.

• Low inflation is important, but, it is obviously not the only macro economic objective. Inflation is above target, but, clearly the prospect of unemployment rising to 3 million should be taken into consideration rather than just worrying over temporary cost push inflation of 5%.
• The government actually state the Role of the MPC is:
• The objectives of the Bank of England shall be
  a) to maintain price stability
  b) subject to that, to support the economic policy of Her Majesty’s Government,
  including its objectives for growth and employment.”
• The MPC could be given flexibility to consider other issues such as house prices / unemployment and balance of payments.

Should Government Take away Independence and control Interest Rates?

I don't think so. I don't believe if the government had been controlling interest rates in the past decade we would be any better off. The government certainly wouldn't have raised interest rates to avoid a boom in house prices. However, the government can change the MPC
s Target - including growth as well as inflation.

• An Evaluation of the MPC in controlling inflation

The Mistakes of Alan Greenspan

Alan Greenspan admitted today, many mistakes were made during his period as Chairman of the Federal Reserve. Greenspan was once hailed as an economic genius who presided over a long period of economic stability. But, now many blame him for fostering an asset boom and bust.

In a remarkable admission, he states how much he underestimated the capacity for banks to take reckless decisions.

"Those of us who have looked to the self-interest of lending institutions to protect shareholder's equity – myself especially – are in a state of shocked disbelief."

In particular Greenspan is criticised for making two mistakes.

1. Keeping interest rates too low in the early 2000s. This caused a boom in demand for houses and encouraged people to take out a mortgage who wouldn't have been able to afford it at normal interest rates. When Greenspan finally had to increase interest rates in 2005, the shock caused many to default.
2. Not Have greater Regulation of Subprime Mortgages and Financial sector. Arguably, Greenspan had the authority to insist on greater regulation of subprime mortgages and financial derivatives. This would have prevented the series of bad loans and unacceptable risks taken by banks.
   

Greenspan admitted that they had poor information about the standards of mortgage lending.

"We didn't know that a deterioration in standards was occurring until 2005. The real toxic mortgages occurred with the increase in securitisation and the huge demand from abroad, and to the extent that Fannie and Freddie were involved, from them as well."

Of course, it is easy to be wise after the event. Greenspan was hardly alone in rejecting calls for greater financial regulation. He was not alone in wanting to keep interest rates low to boost economic growth.

Part of the problem is that policy makers are often making decisions based on past economic and financial trends. For example:

• A Housing market boom and bust has never effected the real economy so much before. Policy makers used to feel targeting inflation was enough.
• There was a widespread ignorance or willingness to turn a blind eye to the shocking practises of subprime mortgage lending.
• Part of the problem was also that the government regulated, Freddie Mac and Fannie Mae were told to make mortgage lending as widely available as possible.

Related

• Boom and Bust in US Housing Market
• What Went Wrong with US Economy
  

In The Long Run We are All Dead - JM Keynes

Readers Question: In an article on the BBC website http://news.bbc.co.uk/1/hi/magazine/7682887.stm John Sloman quoted this: ‘The long run is a misleading guide to current affairs - in the long run we are all dead ‘ JM Keynes

I thought this was very interesting as it puts forward the idea that we shouldn’t bother to think beyond our own lifetime, our own generation. Which I think is a terrible mistake.

This quote came from Keynes' General Theory of Money. During the Great Depression, the prevailing economic orthodoxy was the Classical view. This stated that markets would adjust to disequilibrium without government intervention. Therefore, when the Great Depression occurred in 1930, the classical response was to do nothing - because in the long run the markets would solve the problem (real wages would fall, people would return to work and the economy would return to full employment)

However, Keynes said this was madness - In the depth of a recession, why not try to do something about it, rather than leave to 'market forces'. Yes in the long run, the recession may end, but, here the long run could be 10 years. Keynes wanted to try and solve the depression now rather than wait for 10 15 years or however, long the 'longrun' was.

In particular Keynes criticised the idea that falling real wages would solve unemployment. He argued falling real wages would just leave people with less money and therefore aggregate demand would fall more. Keynes argued for public works schemes, financed by government borrowing to inject money into the economy and get people back to work and spending. This was too radical for the UK Treasury, and generally the UK didn't follow Keynesian policies in the Great Depression. If we had injected government spending, the recession may have been less serious and ended sooner.

See also: Keynesian Economics back in fashion

How Much Should Interest Rates Fall?

Readers Question: In recession it is good to cut interest rate, but to how far should interest rate be cut? What are the disadvantages of cutting interest rate?

It's a good question, and the MPC will be having a big debate amongst themselves how much interest rates should fall. For the past year, David Blanchflower has been arguing interest rates are too high and need to come down more quickly. However, his other colleagues were more cautious, so interest rates have fallen only slowly this year. In the US, interest rates have fallen much more quickly to 2%

Lower interest rates help the economy to recover from recession because:

1. Reduces mortgage payments, increasing disposable income. (Just yesterday I had a letter from Standard Life, saying my interest only mortgage will fall from £627 to £570 a month - I will definitely be spending more!)
2. Cheaper to Borrow for investment
3. Less incentive to save, more incentive to spend.
   
4. Reduces value of Pound, which makes exports cheaper and helps increase aggregate demand.
   

With economic prospects plunging, unemployment rising and manufacturing output falling, there are some people arguing that rates should fall to 2% soon.

What are the disadvantages of Interest rate cuts? - Why are Interest rates not 2% already?

1. Inflation. Lower interest rates typically boost spending and cause inflation. It is the prospect of more inflation which make the MPC reluctant to cut rates. Unfortunately, this year we have seen a rise in inflation to over 5%. This is because of cost push factors, such as rising oil and electricity prices. The MPC have an inflation target of 2%, so in theory normally, they would be considering increasing rates. However, with unemployment approaching 2 million, inflation doesn't seem very important in comparison. Also there is a hope that this inflation will prove only temporary and next year inflation will fall sharply.

2. Savers Lose Out. Interest rate cuts are great for people like me with large debts. But, interest rate cuts are not good for pensioners who live off interest on savings. At the moment, inflation is higher than base rates. Therefore, many savers may see a decline in the real value of their savings. Cutting interest rates to 2% would make them worse off, especially if inflation persists. Savers are often pensioners.

3. More Expensive Imports. Since interest rates have fallen, the value of the £ has fallen. This is due to less 'hot money flows' people wanting to save in the UK. Because the value of the Pound is lower, imports become more expensive. This reduces our living standards and can contribute to imported inflation. (though lower exchange rate is good for exporters)

4. Lower Interest rates may not work. This is a kind of disadvantage. Lower interest rates may not avoid recession. Lower interest rates may not help because:

• Banks don't want to lend. Therefore, even though borrowing costs are cheap, the finance isn't there because of the credit crunch.
• Banks may not pass the base rate cut onto consumers
• Confidence is low therefore people don't spend any more, even though mortgages are cheaper. (e.g. liquidity trap that Japan faced in the 1990s.)

• An Evaluation of the MPC in cutting interest rates
• How the MPC set interest rates
  

National Debt Controversy

Question on National Debt.

Many readers are asking about the true value of National Debt as some commentators are suggesting the real value of national debt is closer to £2 trillion rather than the official figure of £613 billion.

See: Readers Question: What is true level of government borrowing?

Basically, I tried to use an analogy. if you have a loan of £10,000 and in 10 years, you knew you had to pay £7,000 for your children's education - would you include this spending commitment in your level of debt?

Also, if you acted as guarantor for your child's mortgage of £50,000, would you consider your level of debt to be £10,000 or £60,000?

(I know It's not a perfect analogy, but it helps to give a perspective we can more easily relate to)

• National Debt
• Problems of National Debt Statistics
• Who has the highest National Debt? List of countries.
  

Bank admits Recession

The Bank of England admitted for first time, the UK was on the brink of a prolonged recession.
Manufacturers recently reported their bleakest outlook since the 1980 recession.
The pound fell in anticipation of future rate cuts. Many now expect another half point rate cut in November. This is good news for borrowers, but, bad news for savers who will see a bigger fall in the real interest rate.

Manufacturers will see a crumb of comfort in the fact the Pound fell to a five year low, in anticipation of rate cuts. The depreciation in the Pound makes exports more competitive. But, even this may be insufficient to prevent a fall in demand for exports due to the global slowdown.

Pound tumbles on King Warning of recession at Times

Can A recession be avoided?

Why is Dollar Stronger?

Readers Question: I’m just curious about how and why the dollar has strengthened (at least against the Euro and Pound) and why the US would benefit from a stronger USD.

Quite a few people have been asking me why the dollar has been stronger in the past few months. The last time I wrote why the dollar was stronger, it promptly fell by 5%, so let's see what happens this week. :)

USD to Euro Exchange Rate

• US Dollar to Euro. The US Dollar has appreciated from US $1.6 to 1 Euro to US $ 1.32 Euros.
• Against the £ the Dollar has appreciated from US $ 2.0 to £1 to US $ 1.74.

This appreciation of the dollar doesn't represent a changing of the fortunes of the US economy. Economic fundamentals still point to a weak dollar.

1. Current Account deficit
2. Slowing economy and prospects of even lower US deficit.
3. Growing National Debt, which could lead to inflationary pressure.
   
4. US relies on foreign countries to buy about 25% of its National debt. This makes the US vulnerable to China and Japan withdrawing their demand for dollars.
   

See: Why US Dollar is falling. Although written over a year ago, it is still relevant today.
The real worry is that the US becomes so indebted the Federal reserve start to default on the US National Debt, this would cause a run on the dollar. See: Will the US Dollar Collapse

So Why is the Dollar Stronger?

There is a pretty convincing case to say the dollar should be falling. But

1. The dollar has been in along bear market. In the beginning of 2002, the exchange rate was US $ 0.9 / 1 Euro.

1. The recent strength of the dollar should be placed in a longer context. Yes, it has appreciated a little, but, over the past few years, it is has still fallen in value.
2. The Euro and UK economy have deteriorated sharply in the past few months. The strength of the dollar really means the weakness of the UK and Euro economy. The US was the first economy to experience an economic downturn. But, the UK and Euro economies have faced a sharp slowdown in the past few months. This has led to interest rate cuts in UK and Europe. Also investors expect further interest rate cuts in Eurozone and UK because of the impending recession. Interest rates are currently higher in Europe than US, but, people expect European interest rates to fall.
   
3. Purchasing power parity. The US dollar is cheap on purchasing power parity. Europeans going to America find goods to be very cheap.
4. Hedge Funds. Problems in emerging markets are encouraging people to withdraw assets from these countries. Therefore, as these are being sold people are exchanging them for dollars.
   

Is Stronger Dollar A Good Thing?

A strong dollar makes imports cheaper. It reduces inflation and it leads to higher living standards. But, a strong dollar causes less exports. A strong dollar is good during a boom, but, in a recession it can cause slower growth.

Is A Strong Dollar a Good thing?

Japanese Financial Crisis

• Boom and Bust in Housing Market
• Boom and Bust in Stock Market
• Too much bad Lending and Defaulted Debts held by banks
• Economic Growth Ground to a Halt

Sound familiar?

Actually, this time we are not discussing the current UK / US financial crisis, but, the Japanese crisis which began in 1990 and led to a 'lost decade' - over 10 years of a stagnating economy. On the one hand it is foreboding for what could happen in the West. On the other hand, it could be instructive for what we need to avoid.

Why Japan Experienced Economic Crisis.

1. Late 1980s, excess liquidity in the financial system caused an asset and stockmarket bubble. People with spare cash bought assets and shares causing them to rise. However, in the last 1980s, the Japanese monetary authorities were worried about inflation and so doubled interest rates. They were then slow to reduce them.
2. This caused a fall in house and share prices, which lasted 10 years. It is one of the longest bear markets on record.
3. Higher interest rates and slumping asset values caused an increase in loan defaults.
4. Loan defaults were compounded because Japanese banks had made a series of bad lending decisions.
5. The Japanese economic miracle was based on a strong degree of government intervention. IN some respects this worked very well. But, the downside is that the government tried to protect declining, inefficient industries / firms.
6. When the crisis came, banks were encouraged to continue lending to firms, even if on verge of bankruptcy. In other words, the decision to bailout declining / inefficient firms masked the problem but didn't deal with the underlying issues.
7. There was a failure to acknowledge the true extent of the problem, hoping asset prices would rebound (they didn't)
8. Inflation expectations fell to negative. Deflation made normal demand side policies ineffective.
   

Government / Monetary Authority Response

• Cut interest rates to 0%
• Increased government spending to try and increase aggregate demand.
• There was a reluctance to increase money supply, because even when Japan had deflation, they held an unwarranted fear of inflation.
• It was not until 2005, that Japan finally managed to have positive inflation expectations through quantitive easing. This led to first periods of real positive growth.
  

However, these demand side policies failed to stimulate the economy. Because

• Deflation. With prices falling, people wanted to delay buying. Even 0% interest rates were sufficient to encourage consumers to spend. It was a classic liquidity trap. Deflation also increased the real burden of debt increasing problems for firms, consumers and banks.
• Government spending poorly targeted.
• Falling asset prices caused a powerful negative equity effect.

Economic Consequences of Japan's Economic Crisis

• Long Period of stagnant Growth
• Rise in Unemployment. Unemployment was almost unheard of in the post war period. The official figure suggests unemployment of 5%. But, this hides a lot of disguised unemployment.
• Rise in inequality. Issues such as homelessness have become a real problem.
• National Debt has risen to 180% of GDP.

What Can We Learn from Japanese Crisis?

• Cutting interest rates and higher government spending are not guaranteed to kickstart an economy if structural problems remain.
• Asset booms and busts can be very destabilising. But, people and governments tend to ignore them. It is easy to convince ourselves in our case it is not a bubble.
• Government support for ailing firms often only prolongs the agony.

• Asian Financial Crisis 1990s
  
• Addressing financial crisis in Japan
• What Can we learn from Japanese financial crisis?
  

Books on Credit Crisis

At least someone is benefiting from the credit crunch. Apparantely, books on the credit crunch are flying off the shelves. Book companies are offering big contracts to sign up a variety of offers. With the credit crunch developing all the time, 2009, is likely to see more books hit the bookshelves. In the meantime, these are some of the best selling books on the current credit crisis.



The Credit Crunch: Housing Bubbles, Globalisation and the Worldwide Economic Crisis
by Graham Turner - A Critique of the free market policies which created unsustainable booms.



The Crunch: The Scandal of Northern Rock and the Escalating Credit Crisis (Paperback)



The Credit Crisis by George Soros. - George Soros explains the 2008 credit crisis from his point of view.



Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash by Charles R Morris



The Subprime Solution: How Today's Global Financial Crisis Happened, and What to Do About It by R.Shiller

• Credit Crunch Explained
• Essays on Credit Crunch
  

• Books on Financial Crisis at Amazon.co.uk
• Books on Credit Crunch at Amazon.com

Keynesian Economics Back In Fashion

After decades of Monetarism and free market liberalism, it seems 'Keynesian economics' is coming back into fashion.

The term 'Keynesian economics' is a loose one. But, basically involves more government intervention, such as spending more in a recession to try and stimulate the economy. In particular, Keynes was an advocate of greater public spending during a time of recession.

In a recent post, I suggested the government need to increase public spending to avoid the worst of a recession and prevent unemployment rising too much.

Darling said yesterday:

"Much of what Keynes wrote still makes sense. You will see us switching our spending priorities to areas that make a difference - housing and energy are classic examples where people are feeling squeezed. What I want to avoid is getting ourselves in a position governments have done in the past, where you face an immediate problem and cut back on the things the country will need in the future ... we can allow borrowing to rise,"

It was also noted that UK public sector debt is much lower than many of our competitors, giving us room for expansionary fiscal policy. (of course, we could have had more room if the government had been more prudent in the boom years.

It remains to be seen whether we can spend ourselves out of a recession. But, at least it might mitigate some of the effects. The effectiveness of the spending will depend on:

• What is the public spending targeted on?
• Does the spending help to increase productivity e.g. education, transport links can help increase productivity and enable low inflation growth.
• How Bad is the rest of the economy? If banking troubles persist, no amount of injections may be sufficient to overcome the black hole in the economy.

Why Economists Won't Vote McMcain

Mr. McCain was asked in one of the debates how he would deal with the economic crisis, he answered: “Well, the first thing we have to do is get spending under control.”

In a deep and protracted recession, the last thing you want to do is cut government spending. Reducing government spending will reduce aggregate demand and slow the economy even more. By the way this is exactly what the British government did in 1930. When faced with an economic slump orthodox economic response was to balance the budget. So the government actually cut unemployment benefits and public spending. Needless to say, it made the recession much worse causing further falls in GDP. (see: causes of Great Depression)

With evidence of a serious recession: (and evidence is compelling)

• Retail sales falling
• Unemployment rising
• Manufacturing output falling
• Confidence very low
• Investment levels falling
  
• House prices falling
• (To say nothing of all the financial woes)

Fiscal Policy

One of the best ways to stimulate the economy is through public spending on targeted investment projects.

Fiscal policy has many limitations, but, it is more effective than a cut in interest rates. Lower interest rates will have little effect when confidence is so low.

National Debt.

It is true that expansionary fiscal policy will increase government borrowing - already high (National Debt). But, this spending and borrowing is temporary. When the economy recovers, the government should reduce the deficit. The problem is that the government increased spending and borrowing in the boom years. They shouldn't have done this. But, just because they did the wrong thing, doesn't mean we should refuse to increase spending when we actually need it.

Yes, UK National debt will increase, but, if we stay in a protracted recession it will increase anyway.

Price of Ryanair Tickets

Yesterday, I was buying a Ryanair Ticket to Frankfurt, and was surprised at how many different ways they try to make the ticket price more expensive. It makes interesting economics.

From: Leeds to Alicante on 22nd and 24rd Nov

• the cost of the Air fares was £0.00

Taxes and Fees were £46.41. This involves:

• 37.67 GBP Tax and Fees
• 8.74 GBP Insurance/Wheelchair Levy/Aviation Insurance

Airport Taxes

As an economist, I actually don't mind paying airport taxes. Flying has a significant negative externality of greater air pollution and contribution to global warming. The tax makes people pay the social cost of flying. They also raise revenue for the government. If the government were to abolish taxes on flights, it would simply require higher taxes elsewhere. (see: 10 Reasons not to cut petrol tax)

Extra Fees for Ryanair

• Checking in One Bag - £24. Extra luggage does incur a marginal cost of more fuel needed for heavier weight of plane and increased time involved in check in. This is important for Ryanair which rely on quick turnovers. But, I'm sure the cost is not £24. By the way, if you wanted to take a sports bag. The cost will be £50.
• Priority Boarding Be First Passenger - £8.00. This is an interesting ploy. For £8 you can check in quicker and spend more time in duty free and cafes. It is a classic case of price discrimination. It is a way to find passengers who don't mind paying more. Some customers may think £8.00 is not very much so they will pay, even though the benefit is relatively small. For customers whose demand is elastic (sensitive to price changes), they will not pay. Ryanair will definitely profit from this scheme. Overall customers don't get to fly any quicker, it just means some can pay for the privilege to 'jump the queue.' This has been labelled 'Perkonomics' charging customers to get fringe benefits. - see article in Independent
  

• People may say it is unfair, but on the other hand you could argue by charging rich customers an extra £8, they are effectively subsidising lower fares for poor people. If they couldn't gain £8 surplus payments from people willing to pay, the basic ticket price wouldn't be £0.

• Insurance - £7.37 Unless you only fly once a year, it nearly always makes sense to get insurance for a whole year. You can get an annual insurance policy for £40 or less. Buying insurance per flight is a very expensive way to get insurance.
  

• Credit Card charge £8.00 This is a cheeky way to get more money out of you. When you are all ready to pay, you realise whatever method of payment you make there is a charge of £8.00. Even when I choose debit card they wanted to charge £8.00. This is bad because the cost to them is much lower. Debit card charge is no more than 50p. A Credit card is about 2% of price. So they are definitely charging more than the cost. But, when you've got all the way to the end, who is going to pull out because of an additional £8.00 charge? If you knew at the start you had to pay and £8.00 some may not buy. So leaving this charge to the end is clever.
  

Total Cost of Ryanair

• Air Fares = £0.00
• Taxes and Fees = £46.41
• One Bag = £24.
• Priority boarding = £8.00
• Insurance £7.37
• Credit Card Charge = £8.00
• Total = £93.78

Other ways to make money for Ryanair - Selling food, drinks, lottery tickets.

It's like the old adage of a cinema who offer cheap tickets so they can make profit selling popcorn and cola. Ryanair offer 'free flights' because they make so much money charging for extras.

Unemployment in the UK

Source: ONS

Yesterday, Britain experienced the quickest rise in unemployment since the last recession, 17 years ago. Statistics from the International Labour Organisation showed a rise in unemployment to 1.69 million (an increase of 164,000 in the 3 months to August). The Government's claimant count is 978,000. Over the coming months, unemployment is liable to rise to well over 2 million and could reach 3 million the rate of unemployment in the last 2 recessions.

Brief History of Unemployment in UK

Source: Dept for Work and Transport

After the ravages of the Great Depression era where unemployment was over 25%, unemployment in the UK remained relatively low from 1945 until the late 1970s. When Beveridge introduced the Welfare State in 1945, one thing he mentioned was the necessity of maintaining full employment. Using demand management policies and benefiting from a boom in global trade, the UK more or less achieved full employment, until the 1970s. In the 1970s, rising oil prices caused stagflation and unemployment began to rise but was still relatively low.

It was in the manufacturing recession of 1981 when unemployment rose to unprecedented levels. Not only did unemployment reach 3 million, but, it remained stubbornly high until 1986 well into the economic recovery. The huge rise in unemployment was due to the strong value of the Pound, high interest rates and the deflationary impact of strict Monetarist policies. In particular, it was the manufacturing sector that suffered. Male full time, unskilled labour was particularly affected.

Unemployment remained high throughout the 1980s. Even at the peak of the boom in 1989, 1.6 million people were unemployed. This figure involved high rates of structural unemployment (also known as the natural rate of unemployment). This structural unemployment was because the recession of 1981 had made many unskilled workers unemployed. In the fast changing workplace, these former coal miners and ship builders struggled to get work in the new economy. Geographical unemployment was also a strong feature of the 1980s. Former areas of manufacturing and mining, struggled to cope with the large scale redundancies.

In 1991, unemployment rose again, as the economy slipped into another recession. Unemployment peaked in 1993 at just under 3 million. Unlike the 1980s, unemployment fell quicker. From the mid 1990s to 2008, UK unemployment was relatively low. Looking at official statistics, unemployment was fairly close to full employment at just over 3%.

This shows that unemployment is highly cyclical. When the economy goes into recession, unemployment typically has increased to 3 million. If the recession of 2009 is deep, we can expect unemployment to get to 3 million.

Low unemployment was due to:

• Long period of economic growth
  
• Disguised unemployment, many unemployed were allowed to take sickness and disability benefits. Therefore, they are not counted as unemployed. See also: What is True Level of Unemployment?
  
• The Labour Force survey has consistently been higher than the government record of people on Job seekers allowance. This reflects the fact it is very difficult to get benefits these days. Some unemployed are not eligible for benefits for a variety of reasons.

• Regional Recovery. Former depressed areas like South Wales and the North East have been relatively successful in finding new industries to replace the old heavy manufacturing.
• New Deal. Better education and training for the unemployed to get back to work.

Why Unemployment is set to Rise in UK

• Contraction of Credit. Credit crunch has made banks reluctant to lend loans, mortgages and credit. The impact is a reduction in consumer spending, lower investment and lower economic growth. Big investment projects are being delayed until lending becomes easier.
• Global Downturn. The global economy is slowing down, leading to lower exports and international trade.
• Sectors. Certain sectors have been particularly badly hit by the financial crisis, estate agents, banks, construction industry. There will be increasingly a knock on effect to the rest of the economy.

Other essays:

• Is Unemployment a price worth paying for low inflation?
• Types of Unemployment
  

How Much National Debt does the UK Have?

Bonus Joke: "Why didn't the little boy get any pocket money? Cos his mum's gone to Iceland." - sorry :)

• The National Debt refers to the amount the government owe the private sector. The Office of National Statistics state that at the end of August 2008, public sector debt stood at £637.4 billion. (or 43% of National GDP). This includes the £87bn Northern Rock nationalisation.
• With this precedent, it is likely the office of National statistics will include, at least some aspects, of the Government's bailout package as a government liability.
• If the whole £500bn rescue package were to become a contingent liability and put on the public accounts, that would push public sector debt to over 100% of GDP. It is certainly a striking figure. However, this extra £450bn is a different kind of debt.
• So far the government has spent an extra £37bn in buying shares in major banks. This will directly increase public sector borrowing. The government will have to borrow more and sell more bonds and gilts. However, the other £450bn doesn't necessarily imply government's will have to spend more.
• There is £250bn which is to act as a guarantee for bank lending. It will only actually cost the taxpayer if banks default (which is unlikely at the moment)
• Another £200bn of taxpayers money is to be swapped for bank assets such as secure mortgages and loans. The special liquidity scheme is unlikely to cost the taxpayer anything.

Underlying Public Sector Debt.

Even if we don't include the government guarantees for bank loans and the special liquidity scheme. The underlying trend is for government borrowing to rise.

Source: National stats online

Forecasts For National Debt

Unfortunately, short term and long term factors both point to increasing government borrowing. In the short term public borrowing will rise because:

• Recession - leads to lower tax revenues and higher government spending on unemployment benefits.
• Buying shares in leading banks (£37bn so far)

In the long term public sector borrowing is forecast to rise because:

• Ageing population. Old people need more pensions and health care. Less young people to pay tax.

• UK National Debt
• Should We worry about national Debt?
• How is National Debt financed?
  

Inflation Presents Unwelcome Spike for Pensioners

Amidst all the talk of impending recession and possible bank collapse, an inflation rate above the government's target seems of minor significance. Yet, the news that CPI inflation increased from 4.7% to 5.2% will offer no encouragement to the MPC and government.

• The main cause of the inflation is rising gas and electricity prices. Gas prices rose nearly 50% from 12 months ago.
• It is bad news for pensioners who spend a large percentage of their income on heating. It is also bad news for those who rely on savings for income.
• With interest rates cut to 4.5%. It means real interest rates are negative (5.2% - 4.5%) See: Bank of England Website
  
• This means the value of savings is decreasing. Furthermore, RPI inflation which includes housing costs is even higher.
• The only good news is that inflation is forecast to fall sharply in 2009 as the economic slowdown and lower oil prices feed into inflation.
• I don't think that this spike in inflation will prevent the MPC cutting interest rates again in the near future. But, it might make them delay cutting rates, which will harm the prospects of a recovery.

Readers Questions:

I answered 2 readers question at my A Level Economic Blog

• The rate of Mortgage Defaults in the UK
• Questions on Bank Lending

Feel free to ask questions, especially on the financial crisis

Banks in Trouble - Governments to the Rescue

European leaders and now the US have followed the UK example to take shares in struggling banks. Rather than buy bad debts, governments are taking an unprecedented stake in their major banks in an effort to recapitalise their balance sheets.

There was a time when the British Labour party was ideologically committed to nationalisation. The famous Clause IV of the Labour party constitution promised 'common ownership of the means of production' (before Tony Blair changed it - remember the days of New Labour?)

Gordon Brown has said that the government is in the business of protecting banks from going bankrupt and not in the business of running banks. The government has said that whilst the government will take part ownership, it will keep the running of banks at arms length. However, early evidence suggests that this arm may be very short indeed.

Already, the government has shown it can't resist making digs at executive pay and making the banks promise to limit the pay for banks. The government has also apparently made the banks promise to keep mortgages available to first time buyers.

These are both laudable policies, which will be popular with the general public. But, it raises the big question - is it good for governments to meddle in the running of banks and industry?

Arguments for Public Ownership.

Private Sector ignores externalities and social issues. Governments can run industries to maximise social efficiency. For example, private banks may be keen to repossess homes, a government run bank may be able to avoid home repossession. In transport, private run buses and trains ignore the positive externalities involved in public transport. The government could promote

Taxpayer can benefit from Dividends. The government is now a major shareholder in a potentially very profitable industry. The dividends can be used to reduce tax payments.

Market Failure. By pursuing short term profit maximisation, it is argued private firms may make bad decisions which harm the industry and wider economy. The banks inability to understand the risk involved in credit default swaps and speculating on the derivatives market is a good example of this irresponsible 'free market' activity.

Problems of Public Ownership.

Poor Incentives. The argument is that private firms responsible to their shareholders will try hard to maximise returns. Government owned industries invariably lack incentives to compete, innovate and maximise returns.

Government Meddling. The government struggles to resist meddling for political reasons. For example, the government may put pressure on banks to offer attractive mortgages to first time buyers because this will help the housing market. However, critics argue that the government could ignore market signals that house prices need to fall and therefore, artificially keep house prices too high; unwittingly the government could start another boom of excessive mortgage lending. Critics argue that the problem of Freddie Mac and Fannie Mae was government insistence they be willing to lend to all income groups.

• Even limiting executive pay may have its problems. Only the most foolhardy city financer would try to defend bonuses being paid to executives who lead their bank to bankruptcy. But, supposing government owned banks imposed salary caps for executives and managers. The fear is that they would then struggle to attract the best executives and therefore the performance of the bank would suffer in the long run.

Tax Payer is Liable. My hope is that the government have a good deal with buying shares in the banks. But, if things are worse than expected, the taxpayer could be liable for huge losses. This increases the national debt. Also the fact that the government won't allow banks to fail could encourage banks to lose the incentive to worry about bankruptcy.

Related

• Nationalisation of Northern Rock
• Arguments for Nationalisation
• Arguments for Privatisation

Paul Krugman wins Economics Nobel Prize 2008

I was worried that the Nobel Committe were going to give this year's nobel prize for Economics to an economist who did work on the benefits of free, deregulated financial markets.

Thankfully, they choose not to embarass economists. Instead they gave the prize to Paul Krugman.
With his column at the New York Times and several books, he has done a lot to demystify economics and point out the failings and limitations of unbridled free markets. There are few modern economists I actually really like. But, Paul Krugman is one.

• Paul Krugman at Nobel Prize Committee
• Paul Krugman column at New York Times
• Paul Krugman at Amazon.com
  

The Problem With The Iceland Economy

It is easy to dismiss the economic problems of Iceland as being isolated to a small country which produces little other than cod, haddock and the odd volcanic spring. But, unfortunately, the problems which caused the collapse of the Icelandic banking system and currency are replicated in many other countries. We are also finding we have much stronger ties to Iceland than many might have realised.

Reasons for Collapse in Icelandic Economy

Current Account Deficit of over 7% of GDP.

This was indicative of the fact Iceland was importing more goods and services than it was producing. It reflected the high levels of consumer borrowing. A current account deficit of this size puts downward pressure on the currency because it is difficult to attract sufficient capital flows to pay the current account deficit.

• Current account deficit in US is over 5% of GDP (was over 6.5%) UK about 4% of GDP.

Banks Overstretched Themselves.

Following privatisation, Icelandic banks gained assets worth ($180 billion) by the end of 2007, compared with an economy of just €14.5 billion. By the end of 2006 only 30% of loans were backed by deposits. The banks were highly geared, working on tight margins - This is OK in times of fluid money markets. But, with the credit crunch, it became too difficult to raise sufficient short term finance. (The lack of deposits was a reason why Iceland banks were offering the highest interest rates. It was these high interest rates which caused city councils to put their money in) Interestingly Northern Rock failed for a very similar reason - high ratio of loans to assets (44%)

High Personal Debt

Personal Debt in Iceland reached 213% of personal disposable income. In Britain this figure is 164%. In the US, it is 140%. In Germany about 100%. The high levels of personal debt were reflected in the balance sheets of the Icelandic banks who were willing to lend with few questions asked.

High Total Debt.

As well as high personal debt, government and corporate debt mean Iceland's total debt as a percentage of GDP has ballooned to about 350% of GDP External debt now accounts for 80% of total debt. (money week - Iceland)

Inflation of 2008

A booming economy, fuelled by consumer credit caused inflation to rise to 11%. Credit growth to the private sector has exploded from 0 to near 70% year on year. In turn Iceland have had to increase interest rates, just when it will make it most painful for borrowers. At least, the UK and US have avoided this inflation and necessity for higher interest rates.

Loss of Confidence

After the government had to step in and Nationalise the third largest bank Glitnir, investors started to fear the worse. There was a flight from the Icelandic currency and investors withdrew money (Well, except the British local governments who were slow off the mark). This caused a depreciation in the exchange rate and the markets gave Icelandic National debt a worse credit rating, increasing cost of interest payments.

• The loss of confidence was not helped by the perceived bungling of the Icelandic government. E.g. the empty promise to peg the Icelandic Krona to the Euro and trying to secure a loan from Russia.

The irony is that in 2007, Iceland was ranked the 4th richest economy in the world with a GDP (PPP) of $12.144 billion and an estimated GDP per capita of$63,830. It just shows no country is immune from financial meltdown.

• Economy of Iceland at wikipedia
• Iceland Economy at Economist.com
  

Economic Crisis Explained

How Can A few bad mortgages in the suburbs of Florida lead to the Bankruptcy of a country like Iceland? What has caused the stock market to fall by 40% -the worst decline since the Great Depression? And why has the credit crunch pushed the global economy into recession?

The Subprime Mortgage Fiasco Explained

• The Dot com bubble burst in 2001. Shares in internet companies collapsed and with events of 9/11, the US faced recession. The Federal Reserve responded by cutting interest rates to 1% - there lowest level for a long time.
• Low Interest rates encouraged people to buy a house. As house prices began to rise, mortgage companies relaxed their lending criteria and tried to capitalise on the booming property market.
• Mortgage companies actively sold mortgages to people with bad credit, low incomes - often first generation immigrants. This 'subprime market' expanded very quickly.
• Mortgage salesmen were paid on commission. Therefore, they often hid the true cost of adjustable rate mortgages and did little to check whether the homeowners could actually afford repayments in the long term. Even the feeble lending checks were ignored
• Many took out adjustable rate mortgages which were affordable for the first two years, but, then the interest rate increased making mortgage payments much more expensive.
• In 2006, inflationary pressures in the US caused interest rates to rise to 4%. Normally 4% interest rates are not particularly high. But, because many had taken out large mortgage payments, this increase made the mortgage payments unaffordable.
  
• Also many homeowners were not coming to the end of their 'introductory offers' and faced much higher interest rates. This led to an increase in mortgage defaults and companies lost money.
• As mortgage defaults increased the boom in house prices came to an end and house prices started falling.
• The falls in house prices were exacerbated by the boom in building of new homes which occurred right up until 2007. It meant that demand fell as supply was increasing causing prices to collapse, especially in suburban areas.
• The Fall in house prices made the mortgage defaults more costly. If house prices are rising and someone defaults, the mortgage company can get most of the loan back by selling the house. But, now with falling house prices, they may end up with only a fraction of the house value.
  

The Role of Credit Default Swaps

You might imagine that this irresponsible lending by US mortgage companies would mean they would go out of business - end of story. However, the problem of the US mortgage defaults was spread across the financial system.

• Mortgage companies in the US borrowed from other financial institutions to lend mortgages. They sold collateralised mortgage debt in the form of CDOs to other banks and financial institutions. This was a kind of insurance for the mortgage companies. It means that other banks shared the risk of these subprime mortgages.
• Because these subprime mortgage debts were bought by 'responsible' banks like Morgan Stanley, Lehman Brothers e.t.c. risk agencies gave these highly dubious and risky debt bundles triple A safety ratings. Thus banks either ignored or were unaware of how risky their financial position was.
• Therefore, when mortgage defaults in the US occured, many banks and financial institutions around the world had to write off bad assets. E.g. AIG had been insuring many of these mortgage debts so was faced with huge losses
• The extent of this bad debt is estimated by the IMF to be close to £1.3trillion.
  

Freezing of Money Markets.

• In addition to bad debts, the other problem was one of confidence. Because many banks had lost money and had a deterioration in their balance sheets. They couldn't afford to lend to other banks. This caused a shortage of liquidity in money markets.
• Banks usually rely on lending to each other to conduct every day business. But, after the first wave of credit losses, banks could no longer raise sufficient finance.
• For example, in the UK, the Northern Rock was particularly exposed to money markets. It had relied on borrowing money on the money markets to fund its daily business. In 2007, it simply couldn't raise enough money on the financial markets and eventually had to be nationalised by the UK government.
• Because banks were short of liquidity, they have been selling assets such as their mortgage bundles. This caused further falls in asset prices, further liquidity shortages and further deterioration in bank balance sheets. (The Paulson plan is to try to reverse this cycle by the government buying these financial assets no one else wants to buy.)
  

The Vicious Cycle of the Financial Crisis

1. Share Prices

Because banks have lost money, people have been selling shares in banks. This fall in their share prices was speeded up by aggressive 'shorting' of banking stocks. The fall in share prices have compounded the problem of banks because

1. investors / consumers lose confidence
2. More difficult to raise finance on the stock market.

Part of the UK plan is to buy bank share capital to give greater confidence to the banks and enable them to raise sufficient finance.

2. Housing Markets

The shortage of finance means that banks have had to reduce lending, especially mortgages. The shortage of mortgages has caused further falls in house prices, especially in the UK. Falling house prices are magnifying the loss of banks as more default on their mortgage and loan payments.

3. Economy

Falling house prices, shortage of finance and collapsing confidence have caused the 'real economy' to decline. Investment and consumer spending has fallen therefore major economies face recession and rising unemployment. The rising unemployment increases the chance of more mortgage defaults and further bank losses.

Further Reading

• What can we learn from financial crisis
• Different types of economic crisis
  
• A Humorous look at subprime crisis (actually quite educational)
  
• Essays on the credit crunch
• Boom and Bust in US housing market
  

Recession Info and Essays

When I googled 'Why Recession' I noticed that 5 out of the top 10 results were saying that recessions were good. I happen to disagree (unless your the manufacture of soup or a debt collector, recessions are damaging for the economy and more importantly cause economic hardship for many in the economy.) This is a collection of some essays I have written on Recessions in recent months. If you have any other questions about recessions, feel free to leave a comment.

Defining Recessions

• Definition of A Recession
• Simple Guide To Recessions

Are Recessions Good or Bad?

• Can A Recession really be a good thing?
• Does Anyone Benefit from A Recession
  
• Good investments for a Recession
  
• What Happens in A Recession?
• Problems of Recession for Business
• How Damaging are Recessions?

Causes of Recessions

• Video on Causes of Current Recession
• Causes of Great Depression
  
• How Long Do Recessions Last?
• Do Free Markets cause Recession?
  
• Why Recessions can Last a Long Time
  
• How To Survive a Recession
• Causes of Recession - what you would write in an A Level essay
• Do Falling share prices cause Recession?
  

Dealing With Recessions

• Can US and UK avoid Recession? (Jan)
• How To Avoid Recessions
• Can Tax Cuts Avoid A Recession
  
• Problems in Recovering from Recessions

Examples of Recession

• The Great Depression
• UK Recession of 1981
  
• UK Recession of 1991-92
• Why is US Facing Recession - 2008
• Whose Fault is the Recession - 2008
  

Paul Krugman on Financial Crisis

An interesting article at the New York Times by Paul Krugman - Moment of Truth. It explains the need for a coordinated response to an international crisis. It also suggests that the British response of providing capital to banks directly will better help restore the battered money markets. It appears the US Treasury is slowly coming around to the idea that there initial plan to buy toxic mortgage debt is a bad way to spend $700bn.

The Stock Markets have been plummeting again this morning. There is a real danger that if a powerful coordinated response is not generated, the markets could slip beyond our grasp.

In my recent essay on the causes of The Great Depression, it was interesting to note how many similarities there were between 1929 and now. Of course, there are differences, but, it is still cause for concern.

Government Bailout for Monopoly Player (Satire)

Amidst all the doom and gloom (see Economist article - Bad or Worse), I couldn't resist sharing this piece of satire, which wonderfully sends up all the recent government bailouts.

"A game of Monopoly being played by the Henderson family of Watford took a surprise twist today when the Bank of England stepped in with a rescue package to save one of the key players, Mr Henderson, from what the Chancellor described as ‘almost certain bankruptcy.’

The deal, which had been thrashed out in the early hours between Alistair Darling and Mr Henderson, who was acting as the banker, means that each player will receive a £1 billion pound injection of cash, (although this may take some time to count out what with having to use up all the yellow one pound notes). The short-term borrowing deal led to furious protests from the rest of the Henderson family, who complained that it was unfair to use their money to bail out Mr Henderson so that he could go back to ripping them off...."

From: News Biscuit

Difference Between UK and US Bailout

• The UK bailout focuses on recapitalising the banking system. It means government money directly goes to improve the balance sheets of banks. With more capital, it is hoped banks will be able to go back to their business of lending to firms and consumers. Government also offer security to bank loans.
  
• The US bailout focuses on buying bad debts that nobody currently wants. Indirectly, this helps banks balance sheets because they are able to raise money from the sale
• The UK government gets shares in the banks. The US governments gets the toxic mortgage debt and loans.

Overall, I feel the UK scheme will have more affect in securing the banking system. It also means the onus is on banks to deal with the bad debts, rather than the government choosing which debts to buy.

• In the long run, I think owning shares in banks is likely to give the taxpayer the best chance of getting a decent return.
• Interestingly, the UK model follows very closely what Warren Buffet did to Goldman Sachs and General Motors. He bought an investment in these 2 companies in return for preference shares. At the end of the crisis Goldman Sachs and General Motors have the option to buy back these shares for a premium. But, in the short term they get enough capital to avoid a crisis. Warren Buffet is likely to make a good profit on this deal.
  
• Many are now asking why the US government committed to buying $700bn of useless assets when they would be better off directly recapitalising banks and gaining shares for the taxpayer?

Why Recessions Occur

Although there are different definitions of recessions, most go along with the concept that falling real output constitutes a recession. (see: definition of Recession) The reasons for recessions are varied. Each recession has similarities but also differences. These are a few examples of major recessions.


Why Great Depression Occured

• Stock Market crash
• Banking Collapse led to hoarding of money and fall in investment
• Deflation caused even more falls in consumer spending
• End of Boom period and lax credit of 1920s
• Ineffective response of governments. - Failure to rescue banks, failure to increase aggregate demand
• Fall in Money Supply due to bank collapse

Note, some factors are caused by the depression and therefore make it worse. For example, because of the recession, prices fall causing deflation. The deflation made the depression worse. Because of the fall in output, unemployment rose. Rising unemployment reduced spending by more.

Government Blame: 9/10 UK government was stupidly stubborn to try and return to the gold standard on the old 1914 level. US monetary authorities allowed an unsustainable credit boom. The response to the depression made things worse. The UK response to cut unemployment benefits and increase income tax in a vain attempt to balance the budget, highlighted the paucity of economic understanding by economists. Increasing tariffs only made things worse.

See: Causes of Great Depression

1981 Recession

Background: High inflation and wage inflation of the 1970s.

• To reduce inflation, government pursued Monetarist policies. - high interest rates, high taxes and attempted to balance the budget.
• This caused a fall in money supply and inflation, but, in trying to reach a target for money supply, they deflated the economy too much.
• Problems of UK were exacerbated by high value of sterling. Sterling was high because of - discovering oil in north sea and high interest rates.
• The recession particularly affected the manufacturing recession. Manufacturing output fell by a third. Mrs Thatcher claimed recession necessary to get rid of inefficient firms. But, recession was much deeper than necessary. Famous letter to the Times signed by 300 economists criticising the government (see: Economy under Thatcher 79-84)
• UK Economic Recession 1981
  

Government Blame 8/10 - There was a need to reduce inflation the government inherited, but, in sticking to Monetarist principles and targetting misleading money supply growth statistics, the deflation was more than necessary causing recession to be deeper and longer than it should have been.

1991 Recession

Background: Lawson boom of the late 80s. High economic growth, booming house prices and rising inflation. Government claimed their had been an 'economic miracle' and trend rate of growth had increased. But, this was not the case. The boom caused inflation.

• To reduce inflation, the UK joined the ERM in 1990 (fixed value of sterling against the D Mark). The exchange rate value was too high for UK's deteriorating economic situation. To maintain high value of exchange rates, government forced to increase interest rates to 12% (Rose to 15% in one desparate day). These high interest rates reduced inflation, but,
• Caused rise in home repossessions, people couldn't afford mortgages. House price boom turned to bust.
• Falling house prices, high exchange rate and high interest rates caused dramatic fall in consumer spending and therefore recession.

Eventually, UK forced to leave ERM. This allowed interest rates to fall and economy recover.

Government Blame - 9/10 Government allowed an unsustainable boom, believing its own rhetoric of an economic miracle which had not materialised. They then pursued the wrong strategy to reduce inflation - Keeping interest rates stubbornly high to pursue a false goal of exchange rate stability when the real problem was unemployment and falling consumer spending. UK Recession 1991

2008/09 Recession

Background: Stable economic growth and low inflation for much of the 2000s. However, boom in house prices, low saving ratios, expansion of mortgage credit and rise in personal debt.

Causes:

• Credit crunch. Stemming from US, banks lost money in bad subprime mortgage debts. These debts had been sold onto other banks. This meant a shortage of credit in the financial sector. Lending fell, house prices fell and therefore consumer spending and investment fell.
• Cost push inflation. The impact of falling consumer spending and falling house prices was worsened by cost push inflation (rising oil prices) which squeezed disposable incomes.

Government Blame 5/10. Governments weren't the main perpetrators behind the credit crisis. But, they can be criticised for lack of sufficient regulatory oversight. US government could have done more to prevent a housing bubble and bust and excessive growth of consumer debt and borrowing
Oil price increase beyond governments control.
Credit crunch, collapsing banks and cost push inflation gave Government difficult problems to deal with.
See: Video on Causes of Current Recession

Of the 4 recessions, highlighted here, I am inclined to blame the government the least for the current recession.