UK Public Finances

Readers Question: Why is the UK’s public finance position considered worse than other major economies when the UK has the lowest percentage of National Debt to GDP when compared to these other economies? (i.e. UK debt 43%, Germany 64.9%, France 63.9%, US 72.5%, Italy 107%, Japan 194%)

I think there are a few reasons.

1. People Always Imagine the Worst

I think if you went to France, Italy, US, Ireland, people in those countries would probably think they have the worst state of public finances. It is the nature of the national media to exaggerate the extent of economic problems. It hardly makes a good headline to say:

'UK National Debt increases, but, is still significantly less than our main international competitors'

Rapid Deterioration.

One thing about the UK public finances, is that although National debt is 'relatively' low, next year will see a rapid deterioration. In the next financial year, Government borrowing is estimated to be £115bn or 8% of GDP. This will increase National Debt from £512bn to £627bn - that's a pretty rapid increase. Because growth is negative, national debt as a % of GDP will jump significantly. If the recession continues, it could be very difficult to prevent a continued rise in public sector debt as a % of GDP. Germany by contrast has worked hard to improve its fiscal position. Even though it is in recession, they somehow have managed to balance the budget. (They should now pursue expansionary fiscal policy and borrow more, but, they have become rather proud of their balanced budget.)

Claims UK Debt is Alot Higher

The Institute of Fiscal Studies claims public sector liabilitie is a lot higher - if the government includes PFI Initiatives and public sector pension liabilities. Therefore, because of this some suggest the true level of public sector debt is already over 100% of GDP. However, this is to confuse net debt with net liabilites. They are just liabilities - they have not incured borrowing yet. However, it is a guide to the future strains on public finances the UK may face. You can see IFS report here -pdf

• Also, it should be remembered other countries have similar pension liabilities. Countries like Japan and Italy will face much more pressure on public finances because there demographic trends are much worse than the UK. See global demographic trends

Low Savings in UK

The UK could not cope with national debt of 195% of GDP like in Japan. Japan can cope because it has very high levels of personal savings. Therefore, people are willing to buy the government's debt. The UK doesn't have the necessary level of savings for government to borrow 195% of GDP. However, as the recession bites, savings are increasing, and at current levels, the government will be able to finance the increased levels of public debt.

The UK situation is bad, government borrowing is increasing very fast. But, the UK is not facing imminent bankruptcy as some of the shrill tabloid headlines would like us to believe.

It is difficult to compare countries public sector debt, but, it also worth examining the cost of paying interest on the public sector debt. Last year UK spent £31bn on interest payments - Alot, but, still affordable.

• UK National Debt
• National Debt Controversy
• List of National Debt by Country
  

Balance of Payments Statistics - Should We Worry?

UK Current account deficit. Source: ONS

With unemployment rising and national debt heading towards the £1 trillion mark, very little attention is being given to the UK's current account deficit. Many people struggle to understand what the current account deficit actually is. (My economic students often erroneously assume a current account deficit means the government is borrowing from abroad) A current account deficit means the value of imports of goods and services is greater than our exports.

A current account deficit means more foreign currency is leaving the economy than coming in. Therefore, we need to finance this current account deficit by having a surplus on the capital and financial accounts. This involves savings in UK banks, hot money flows and long term investment.

To give a simple example, if we have a trade deficit and are importing Chinese toys. The Chinese may use their export revenue to buy British government securities or save in British banks. Therefore, we gain the foreign currency to be able to afford the Chinese imports.

• Therefore, some argue that in an era of global capital flows, a current account deficit is nothing to worry about. A country like the UK can easily attract capital flows and investment and this will finance the deficit. If we can't attract the necessary capital flows, the Pound will devalue and this devaluation will change the terms of trade to improve the current account.
• Furthermore, you could argue that these capital flows are beneficial. For example, Japanese investment in building new factories in the UK provides a boost not only on the Balance of Payments but also in increasing productive capacity.
• A current account deficit also helps to improve living standards because consumption levels are higher.

However,

• The Credit crunch shows that the hope of free flowing capital can soon coming crashing to an end. - Just look at Iceland. Iceland were running a current account deficit of over 7% of GDP. This was fine whilst international investors were willing to save in Icelandic banks. But, the credit crunch caused people to withdraw their money away from Iceland. As people withdrew their capital the Icelandic Krona collapsed causing a loss of confidence in economy and reducing living standards.
• A current account deficit can lead to higher interest rates. To attract hot money flows and keep money in the country, Iceland and Hungary have had to keep interest rates high. This leads to lower growth and higher borrowing.
• With a large current account deficit, the country always faces the possibility of a large devaluation. Devaluation in the currency can be damaging because it will:
  

1. lead to inflation
2. higher price of imports and cost of living
3. loss of confidence in the economy.

Of course, devaluations can help boost exports, growth and they will reduce the size of the deficit. But, if the devaluation is too sharp it generates a negative momentum and loss of confidence in the economy.

Current account deficits are not necessarily a bad thing. Similarly a current account surplus is not the sign of a strong economy. Japan had a huge current account surplus during its lost decades of deflation and recession. However, current account deficits are a problem if they became 'unmanageable'. This is anything over 5% of GDP, but, of course varies from one country to another. The real problem comes if the balance of payments also involves external debt and the country can't repay.

There is also a danger of relying on hot money flows and a fluid money markets.

Should the UK worry about current account deficit of 3% of GDP?

The recession and devaluing pound should improve the deficit. But, the persistent deficit suggest the UK economy is unbalanced and the economy would benefit from diversifying and encouraging exports and manufacturing.

• Should we worry about a current account deficit?

Ownership of the Bank of England

A while back I wrote a post, in response to a readers question - Who Owns the Bank of England?
I have been surprised:

1. How many people search that question on Google
2. How many people don't believe the explanation. For some reason many people think it is owned by the Rothschilds.

I wrote to the Bank of England asking for clarification. This is how they replied:

The Bank of England is the central bank of the United Kingdom and was established as a corporate body by Royal Charter under the Bank of England Act 1694. The Bank was nationalised on 1 March 1946, and gained operational independence to set interest rates in 1997 (the Bank of England Act 1998 Part II sets out the responsibilities and objectives of the Bank in relation to monetary policy).

The Bank is a public sector institution, wholly-owned by the government, but accountable to Parliament. The entire capital of the Bank is, in fact, held by the Treasury solicitor on behalf of HM Treasury. Each year, the Bank is required to submit its Report and Accounts to Parliament, via the Chancellor of the Exchequer. For more information you may be interested to see the Bank's latest Report and Accounts, which can be found on our website at:

Bank of England Annual Reports

As to the supposed 'Rothschild' connection, I don't know why people should think that the family own us. But a number of the Rothschilds have served on the Bank's Court of Directors over the years.

Interestingly, there is a similar conspiracy theory about Who owns the Federal Reserve? - Again many people believe it is owned by private bankers such as the Rothschilds and it is intent on fraudulently extorting billions of pounds from honest hard working Americans.

National Debt

A video on National debt.



A few comments on video.

• I think US National Debt is a serious problem. US National debt is already 73%, but the US bailouts and rescue packages are greater than the UK.
• I mentioned the Labour government of 1931 increased taxes and cut unemployment benefits. Actually, it was a National government headed by Ramsey McDonald filled with mainly Conservatives. Most Labour MPs resigned.
• It is OK if National Debt rises now, so long as it is reduced when the economy recovers.
• The real fear if we were to have a deflationary decade of stagnant growth like in Japan. Unlike Japan, UK and US could not support a national debt of 195% - we simply don't have the necessary domestic savings.

UK National Debt

• How is National Debt Financed?
• National Debt Controversy
• National Debt by Country
• US National Debt

A week of stupid politics but good economics - Anatole Kaletsky

Irresponsible Borrowing

"It was borrowing that got us into this mess, so why is the government borrowing to get us out?"

It was not government borrowing that got us into the mess. It was irresponsible bank lending.

• The roots of the current crisis lie in US Subprime mortgage markets where banks loaned mortgages to people who had little chance of repaying them back.
• For more on the roots of the subprime mortgage crisis see - Who is to Blame for credit crunch?
• The mortgage defaults led to banks losing money. The subprime mortgage crisis spread to the UK mainly because British banks relied on raising money through money markets. As the mortgage companies lost money, it was difficult to raise money on the money markets so banks like the Northern Rock had liquidity shortages.
• Because the banks had a shortage of liquidity, they cut back on mortgage lending making it very difficult for homeowners to get a mortgage. This precipitated the slide in house prices which caused a fall in consumer spending and lower economic growth.
  

Personal borrowing in the UK increased on the back of rising house prices. This willingness to borrow and take out large mortgages helped fuel a boom in house prices. This means that the consequent fall in house prices is larger.

But mainly the recession was caused by the financial crisis which led to a decline in normal business and consumer lending. This shock to the economic system has led to a decline in growth.

Because growth is falling, the government is trying to stimulate the economy through tax cuts and higher borrowing. The last thing the government wants to do in a recession is to balance the budget. This would just make the current downturn worse.

It is true that Government borrowing has been rising in previous years, even before the recession. from 29% of GDP in 2001 to 37% of GDP in 2007. This now looks irresponsible in the sense the government doesn't have a war chest to stimulate the economy. However, this increased borrowing did not cause the current recession.

Do Economic Stimulus Packages Work?

Yesterday, the Chancellor, Alistair Darling announced an economic stimulus package worth over £20billion. [Times link] It raises the prospect of national debt rising from £512bn to £1 tn in a couple of years. With the UK Economy already facing a recession and rising national debt, will the recovery package work?

The justification for the economic stimulus:

• Borrowing is justified because it will stimulate spending and encourage economic growth. With falling house prices and low confidence, tax cuts are an essential way of encouraging people to spend and avoiding a sharp deflationary downturn.
• The sooner the economy recovers the sooner tax revenues will start to rise and the government can stop paying unemployment benefits. If the government doesn't borrow now to kickstart the economy, the recession will be deeper and therefore borrowing will rise anyway.
  
• The tax changes are progressive. Cuts in VAT tend to have a relatively bigger impact on low incomes because they have a higher propensity to spend. Tax increases are focused on those earning over £39,000 (higher rate of income tax will rise to 45%)
• National Debt will rise. But, that is to be expected in a recession.
  
• With interest rates low, the cost of servicing national debt will remain manageable. (national debt interest payments are currently £31bn or 2.5% of GDP)
  
• The traditional concerns of higher national debt are often exaggerated. National debt rarely leads to higher interest rates and increased money supply. Stimulating the economy is more important than worrying about National Debt.
• National Debt in the UK has been much higher than the current 43% of GDP. e.g. in 1970 it was 70% of GDP.
  
• By planning tax rises, the government has made a commitment to bringing national debt under control when the economy recovers and can absorb tax rises. The fact the Pound rose yesterday, suggested the markets approved of the government's stimulus package.

Problems of the Economic Stimulus Package

• Cutting VAT may not stimulate spending because consumers are looking to pay off debt and increase their savings.
• Cutting VAT will encourage spending on electronic goods and other expensive imports. Imports don't help UK aggregate demand, but will worsen the current account deficit.
• Administration costs of changing VAT prices of goods is quite high especially for small business.
• The proposed tax rises are very modest in comparison to the rise in National debt. e.g. the increase in the higher rate of income tax from 40% to 45% may only raise about £1.5bn
• Government borrowing of £80bn is failing to stimulate the economy this year, so why should borrowing of £118bn next year do the same. Japan increased national debt to 195% of GDP without boosting the economy.
• If more banks need nationalising would the government be able to do it?
  
• Because the government has pursued expansionary fiscal policy, the MPC may have less room to cut interest rates.

What Would I Have Done?

In a recession, I do believe in pursuing expansionary fiscal policy. Temporary tax cuts, will help mitigate the impact of falling spending and hopefully lead to a shorter recession. The rise in National debt is a concern, but, at the same time it is just about manageable. People often point to the experience of Japan as evidence expansionary fiscal policy fails. But, that was because Japan was suffering from deflation. The main benefit of this expansionary fiscal policy is ensuring deflation doesn't occur in the UK. If we avoid deflation, then I would expect the UK economy to recover at the end of 2009. Then will come the necessary tax rises. As an economist I don't mind the fact that taxes will rise during economic recovery.

• UK Economy 2009 - analysis of problems UK Face
• Can a recession be avoided?
  

Economics of Saving

To Save or Not To Save?

A prominent feature of the past few years has been a marked decline in the savings ratio. The UK Savings ratio has fallen from 13% in 1992 to a record low of 1.1% in September of this year 2008. In the US, saving ratios have fallen by a similar amount.

Many economists suggest that the current financial turmoil reflects a lack of prudence by both consumers and financial institutes - and this is reflected in a falling savings ratio. So why was the US Treasury proposing to use $25 billion to help boost US consumer credit? Is saving good or bad? Should we really be encouraging people to spend more when the economy actually needs a higher saving ratio?

The decline in the savings ratio reflects:

1. Rising House and asset prices. As house prices rise people remortgage and feel more confident to spend.
2. Increased willingness to borrow and take on debt.
3. Higher confidence about economy.
4. Relatively low interest rates

Problems of Low Savings Ratios

1. The decline in the savings ratio reflects the boom years where people borrowed heavily to finance spending and get on the property ladder at any cost. Rather than save a deposit for a house, people would get a 95% or 100% mortgages. This exacerbated the boom in prices and now is leading to negative equity.
2. Consumers have little margin for error. Lower incomes or rising living costs, mean people have little backup.
3. Current Account deficit. It is no coincidence that countries with low saving ratios tend to have current account deficits. This is because with low savings, there is high spending on imports. Large current account deficits increase the likelyhood of currency devaluation such as US dollar since 2000 and Iceland this year.
4. Is reflected in banks balance sheets. The problem of Northern Rock is that they financed the majority of their mortgages not by savings and customer deposits but by borrowing from other banks.
5. Low saving Ratios imply less investment. It reflects a choice to have greater living standards now at the expense of the future.

So Should We save More?

In the long term, a higher saving ratio would be desirable. It would help shift the economy from a consumer led growth to a more balanced economic growth. However, a sharp rise in the savings ratio at the present moment would be damaging. Look at the experience of Japan. Japan have a huge current account surplus and huge array of foreign currency reserves. But, it led to stagnant growth for the next 10 years and a national debt of 195% of GDP. (updated)

In a recession, we don't want spending to stop completely. If the savings ratio suddenly shoots up, the decline in consumer spending would be much greater and the recession deeper. Keynes pointed to a phenomena known as the 'paradox of thrift' - In a recession people instinctively save more, but this makes the recession worse.

For the next 12 months, we want to avoid a very painful slowdown. But, when the economy recovers, we need to try and create a situation which encourages a higher level of saving. Above all, we want to avoid another credit led boom. But, just at the moment increasing the savings ratio is not our highest priority.

• To paraphrase the words of Saint Augustine - "Lord, make us virtuous savers - But Not just Yet".

(The actual quote from Augustine's Confession "Lord, make me pure, but not yet")

• Savings Ratio UK

It's Grim up North (and East, South and West)

Remember when recessions mainly affected manufacturing in the north? (UK recession 1981)

A feature of the current recession is that it is affecting previously insulated sectors of the economy. Most notably, we are seeing record falls in consumer spending in both UK and US. For example, in the last US recession 2001, consumer spending never actually fell, but, now it is falling dramatically. In the UK, the sales slowdown has been somewhat mitigated by early pre-Christmas sales. But, with retail giants like Woolworths potentially being put on market for £1 [WSJ], these are going to be very tough times for retail. The impact of the recession on the financial service sector is well documented. Falling share prices will continue to put pressure on city jobs.

Global Slowdown Spreads East

India had hoped (expected) to avoid the global slowdown, but, to the unpleasant surprise of many politicians, India is feeling the squeeze as banks cut back on lending, the stock market falls 50% and consumer spending growth declines. This has caused India's growth rate to fall from 9% to 6.5%. This may still sound very attractive (compared to our negative growth), but with India's population growth and large increase in working population any slowdown in growth will cause unemployment to rise. (India's slowdown) China fears a similar fate.

Many Indian economists hope that the downturn will prove only temporary, but, there optimism may prove misplaced (as it has in other countries). In a global economy, the idea of 'decoupling' and insulation from economic downturns carries little weight.

There is an old saying 'When America sneezed the rest of the world catches a cold.'

Unfortunately, this still seems very true. Actually, it wasn't just even America sneezing. It was a seemingly small problem in the US subprime mortgages sector that has given the global economy something much more serious than just a cold.

• Current Economic crisis Explained
• Who is to Blame for Financial Crisis
  

National Debt Explanation

One Myth of National Debt - "An increase in government borrowing means taxes will have to rise in the future."

This seems so obvious that it is repeated as an unquestionable truth. However, it is not necessarily the case.

Let us assume:

• Economic growth of 2.5% (The UK has average growth of 2.5% since 1945)
• The government increase spending by 1% in real terms. (this takes into account inflation) but don't change tax rates,
• If we have economic growth of 2.5%, this means that tax revenues will be rising by approximately 2.5%.
• People will pay more income tax (even if rate stays at 23%)
• People will buy more so the government will receive more VAT (even if rate stays at 17.5%)
• Companies will pay more corporation tax.
  

Therefore, although the government is increasing its real spending (1%), its real tax revenue is increasing at a faster rate (2.5%). Therefore, government borrowing will be falling.

Falling National Debt as % of GDP

• If government increases spending by 3%. Then government borrowing will have to increase because spending is rising faster than tax revenues. Therefore, National debt will be increasing in real terms.
• However, although borrowing increases by 0.5%. Economic growth is higher 2.5%. Therefore, even though the government is borrowing more, national debt as a % of GDP is falling. If National debt as a % of GDP is falling, then a smaller % of tax revenues are needed to finance the government's debt interest payments.
• For example, in 1997, government borrowing was £18 billion for the year, but national debt as a % of GDP fell.
• Between 1998 and 2000, the government budget actually had a surplus, leading to a sharp fall in national debt as % of GDP)
  

Increasing National Debt as a % of GDP

The problem comes when the government increase borrowing at a rate faster than economic growth. In the period 2003-07, the UK significantly increased the government spending on NHS and education, this caused government borrowing to rise faster than the rate of economic growth. Therefore, public sector debt as a % of GDP increased from 29% to 35% of GDP.

Now, we are in recession, tax revenues are falling and government borrowing is increasing, therefore, we will see a sharp rise in national debt as a % of GDP. It will increase the % of GDP we have to devote to interest payments on national debt.

One reason Japan has such as a high national debt as % of GDP is that it has borrowed and there has been stagnant growth for over a decade.

• However, when the UK returns to normal growth patterns (and it may take longer than we would like), we should see national debt as a % of GDP fall.
• Therefore, increased borrowing doesn't necessarily have to lead to higher taxes in the future.
• The other argument is that government borrowing stimulates the economy and as the economy grows, tax revenues will rise to pay off the temporary borrowing.

• UK National Debt

Deflation vs Inflation

Source: US Bureau of Labor statistics (showing deflation in early 1920s and 1930s)

In the MPC's last monthly inflation report they forecast that inflation could fall to 1%. They even hinted at the possibility of deflation. What is deflation and why does it strike fear into economists and policy makers?

Deflation is simply a fall in the general price level. If this deflation a result of improved productivity and greater efficiency, it could be benign. But, usually deflation is caused by falling demand and lower growth. It is no coincidence that our worst period of deflation was in the great depression of the 1930s. This kind of deflation is very damaging because:

1. Lower Spending. When prices are falling, there is an incentive to delay purchases. Why buy a TV now, when it will be cheaper in 12 months? Look at how the housing market is suffering because of falling prices. Nobody wants to buy with falling house prices; this is why property transactions have slumped and of course causes further falls in prices. In Japan, the decade of deflation created a culture of thrift and saving. Japanese housewives just wouldn't spend. Tax cuts, government spending and interest rate cuts all failed to stimulate growth because all the Japanese wanted to do was save (an example, of the Paradox of thrift)
2. Liquidity Trap. A liquidity trap occurs when lower interest rates fail to stimulate spending. If prices are falling by 2%, it can be more attractive to save money in cash then spend. Therefore, cutting interest rates to 0% may be ineffective in increasing demand.
3. Increasing Burden of Debt. If you take out a mortgage and make mortgage payments of say £500 a month, inflation will progressively reduce the real value of your mortgage interest payments. High inflation thus makes a mortgage more attractive, over time, it increases the disposable income of mortgage owners.

• However, with deflation, this £500 a month becomes a bigger % of your disposable income. In deflation, debt becomes an increasing burden reducing spending and economic growth.

• The problem is that the UK and US are increasingly indebted, personal savings are very low. Personal debt is very high therefore, deflation would be very damaging for an economy burdened with a legacy of debt.
• 4. Rising Real Wages. Workers will general seek to prevent a cut in nominal wages. Therefore, with deflation, real wages rise by stealth. This can lead to real wage unemployment. With deflation, it is much more difficult for prices and wages to adjust.

How To Overcome Deflation.

Basically, Monetary authorities need to implement bold policies. In particular they need to increase inflationary expectations. The problem is Central banks are so used to trying to reduce inflationary expectations, that they can struggle to implement the opposite. However, the experience of Japan in the 1990s and 2000s suggests timid policies can lead to several years of economic stagnation.

• Costs of Inflation
• What is more likely inflation or deflation?
  

Fall in Inflation and Rise in Prices

Source: ONS

The ONS reported a significant drop in the inflation rate from 5.2% to 4.5% in October. This is the biggest drop in the inflation rate since April 1992. This means prices are now rising by 4.5% a year.

I noticed one comment about this statistic which is quite common:

"Inflation isn't falling ! It is rising at more than double the governments target. Things are still rising in price by 4.5% !!!!"

A fall in the inflation rate means that prices are increasing at a slower rate. Yes, prices are still rising, but, there has been a fall in the rate of inflation. - prices are increasing at a slower rate.

• This inflation figure is what we might can a backward looking statistic. If we look at producer price inflation. Prices are actually falling.
• Producer inflation was -1.0% in October. [Bloomberg] This is the biggest drop in producer prices since records began in 1986.
• This producer price deflation is a guide to inflation next year. It suggests why inflation is in danger of undershooting the government's target of 1%.
• Definition of Producer inflation Producer inflation reports the price of goods leaving the factory gate. If the price of manufactured goods are falling, in due course, retail shops will be able to pass these lower prices onto consumers.
• The fall in inflation increases the chance of another rate cut in December.
  

General Motors Bailout or Bankruptcy?

America - the land of freedom, opportunity, free markets and government bailouts.

It's not a good time to be a car manufacturer. Several years of over supply have been exacerbated by a slump in global demand. Even falling gas prices have done little to revive a car market in the doldrums. General Motors is on the verge of bankruptcy, and it presents politicians with a difficult dilemma of what, if anything, they should do.

The Case for A Bailout.

1. Unemployment. One in every 10 US job relies directly or indirectly on the car industry. Allowing General Motors to go bankrupt would exacerbate US unemployment at a time when it is rising fast already.
2. Recession. With the US in recession, a government subsidy could be justified on the grounds of expansionary fiscal policy. If General Motors was to close down, the resulting unemployment and loss of confidence would cause a further fall in economic growth.
3. Equity. The US government has bailed out (undeserving) insurance and banking giants, why should the government then ignore the ordinary worker? It wasn't the blue collar workers in Detroit who caused the current financial / economic turmoil so arguably they 'deserve' a bailout more than reckless banking managers and hedge funds.

The Case Against a Bailout

• It Will Only Delay The Inevitable. You could try to argue that General Motors is merely facing a temporary blip due to the recession, therefore, a subsidy to help it through the next 1 year of recession is all that is needed. Unfortunately, this is not the case. General Motors was facing difficulties even during the boom period. The fundamental problem is that there are too many cars being produced in America. A government subsidy only encourages this oversupply to continue.

• There is no guarantee that pouring more money into General Motors will actually solve the problem. GM said earlier this month that it had burnt through $6.9bn in the three months to the end of September and had drawn on the last of its credit lines from its banks. In 12 months time, they could be coming cap in hand asking for more money. The problem is that once the government starts bailing out General Motors it may find it very difficult to extricate itself. The government won't want to lose its initial investment so it will keep pouring in money into a failing company.

• Will people buy from a bankrupt Car firm? General Motors may be given a lifeline from the government. But, will consumers trust general motors will be there in a few years. The problem is that people may not want to buy a car from a firm on the verge of bankruptcy.

• Government subsidies rarely work In the 1970s, British Leyland was going bankrupt due to inefficient management, poor industrial relations. Because it employed so many people the UK government subsidised the firm and kept it going for another few years, but, this subsidy did nothing to turn around the company. There is no evidence that US subsidy would be able to transform General Motors.

• Employment Patterns change. In 1945, 0.45 million people worked in British coal mines. In 2009, that figure is less than 5,000. Should the UK government have subsidised coal mines to prevent 450,000 jobs in the coal industry being lost? The simple answer is no. Although the recession will make the transition more difficult, the government should not insist on trying to avert the necessary change in the American car industry.

• Externalities. Why should government subsidise General Motors who do little to develop alternative / cleaner energy? Why doesn't the American government subsidise new firms producing bikes / trains / cars which run on renewable resources. At least then you could justify the subsidy on the grounds of external benefits.

• Car Industry is Not indispensable. American car workers probably do deserve a bailout more than irresponsible banks, but, unfortunately, public policy cannot always be dictate by who is deserving of a bailout. A banking system collapse would really harm the economy in a way that a car firm bankruptcy never would. The UK used to have a very important car industry, but, now we have no significant UK car firms, but, it is not the end of the economy.

Conclusion

From an economic perspective, it is hard to justify a huge government bailout for a declining industry. It is a very expensive and inefficient way, to prevent unemployment. If the government really have $25 billion to try and protect jobs in the car industry, they might be better off letting General Motors go under, and use this money to try and retrain workers, and stimulate investment in the towns most affected. At least the government would have something to show for their money, rather than pouring it down the black hole of General Motors accounts. The government could then say at least it is trying to help deal with the very high human cost of General Motors bankruptcy.

Run on the Pound - What's the Panic?

Recent observations by shadow chancellor, George Osborne about government policies threatening a run on the Pound has led to a spate of concerns over the future of Sterling. Many seem to take it for granted that the recent fall in the Pound (25% against dollar) 17% against Euro is just the start of a huge devaluation threatening the future of the economy. Rather bizarrely, Will Hutton suggests that this devaluation of the Pound gives us good reason to join the Euro [article at Guardian].

Here are Reasons Not To Panic at a Falling Pound:

1. Fair Value of the Pound. At $2 to £1, the pound was overvalued. This summer the IMF suggested a fair value of the £ was £1 = $1.5. The recent devaluation partly reflects a correction to a long period of overvaluation.
2. We are all doing badly. People see the falling Pound and imagine the UK alone is going into recession and increasing government borrowing. Actually, Germany has recently announced recession and poor old Japan announced yet another official recession today. The US economy is on the brink of a very serious recession. UK public sector debt is amongst the lowest of our main competitors.
   
3. A Falling Pound is not such a Bad Thing. A depreciating pound makes exports cheaper and will help UK manufacturers. True, there isn't much global demand anyway, but, a devaluation will be much more welcome than an appreciation. Usually the problem of a falling pound is that it causes inflation. But, with the most prolonged recession in 2 decades, inflation is the least of our concerns.
4. Improve Current Account Deficit. For the past 2 decades, the UK has mostly been running a persistent deficit in the current account. The economy has relied on consumer spending, imports and hot money flows to finance our consumer spending. The fall in the pound will help restructure the economy away from consumer led growth and reduce our persistent current account deficit.
   

Should We Join the Euro to Protect the Pound?

No, In the last recession of 1992, the big mistake the UK made was to strive to keep an artificially high value of the Pound, when it gave no economic benefit. It became only a matter of pride and stubbornness. But, keeping a high pound (which required high interest rates) only deepened the recession. In a recession a falling pound is more of a boon than curse.

Furthermore, the last thing the UK wants to do is surrender monetary policy to the ECB. If we do that, there is a grave danger the ECB could set interest rates higher than the UK needs. The benefits of the Euro are minimal, the disadvantages potentially huge.

Excellent article by Anatole Kaletsky at Times - Pound's fall will herald recovery

The Demographic Time Bomb

Forecast for Dependency Rates

Source: Dept for work and Pensions

Many Western OECD economies are facing an unwelcome population projection. As the baby boomer generation starts to retire (around 2016), the dependency ratio (number of people not working to number of people working) is forecast to rise. This ageing population is exacerbated by declining birth rates which is reducing the number of working age adults. Some countries are affected more than others. For example:

• Italy number of adults 16-65 is forecast to fall from 35 m to 26.1 m. Combined with an ageing population and a National Debt of over 100% to start with it looks pretty grim.
• UK Dependency ratio is forecast to rise from: 0.34 to 0.65 by 2040.
• In the US statistics from federal reserve suggest a fall in number of workers to dependants from: 0.63 to : 0.53 in 2080
  

Impact of Ageing Population

• Fall in Income Tax Receipts. Retired people will pay very little if any income tax.
• Increased spending on Pensions: Governments are committed to make pension commitments to everyone over the age of 65.
• Health Care. 50% of health care is focused on people in the last year of their lives.

The government will be faced with higher spending commitments and lower tax receipts. If the government doesn't radically change policy, national debt is likely to increase. Furthermore, the government will not be borrowing to finance sustainable investment but making transfer payments which don't boost productivity.

Is it Really The End of the World?

Some doomsayers suggest that the ageing population could really cripple western economies leaving governments with unmanageable debts - leading to inflation and / or higher interest rates. However, bear in mind.

Source: National Bank Denmark

• Some Countries are much more affected than others. The outlook looks bleak for Italy and Japan, but, not too bad for UK, Denmark and US.
• There will also be a decline in young dependants (people under 16). Therefore, the government will be able to spend less on education and child benefit.
• Economic growth of 2.5% should increase the nations capacity to meet rising spending commitments. If economic growth averages 2.5% and national debt increases by 2.5%, then national debt as a % of GDP will remain the same. This means that tax rates will not have to rise to meet interest payments on the consistent national debt. The problem will come if National debt increases faster than economic growth.
• Compared to the 1960s and 1970s, female labour market participation rates have dramatically increased. This helps increase the number of effective workers to economically inactive. (However, this has been offset to some extent by declining male participation rates.)

What Choices Do the Government Have?

With prospect of higher spending and relatively lower tax receipts, the government may have to consider some politically unpopular policies.

1. Raise retirement age to reflect longer life spans. In 1950, average life expectancy was 75. It is now 86. But a higher retirement age will not be welcomed by people who have been planning and expecting to retire at 65. Governments may delay implementation of higher pension age for several years.
2. Higher tax rates. Increasing income tax to pay for an ageing population hardly inspires. The argument is higher tax rates will reduce productivity and deter people working. The impact of higher taxes on labour productivity is less than many claim, but, it would still be an unwelcome development
3. Cut spending. Making people pay for private health care and private nursing homes is one solution. But, it would inevitably require an extensive and unpopular means tested scheme to decide who can't afford. It won't please children seeing a fall in their inheritance levels.
4. Immigration. Immigration of young workers will be one of the easiest solutions to the demographic time bomb. But, immigration is equally unpopular.

The problem is arguing for the above policies is hardly going to win you favours with the electorate, therefore there is a politically pressure to keep delaying these policies for later. Which policy would you be happy to accept?

Government Borrowing and Collapsing Pound

The shadow Chancellor, George Osborne suggested that government tax cuts and borrowing could lead to the collapse of the Pound. (Brown borrowing could destroy the Pound at Independent)

"We are in danger, if the Government is not careful, of having a proper sterling collapse, a run on the pound.

"The danger of a run on the pound . . . is that it pushes up long-term interest rates, which is a huge burden on the economy.

"The more you borrow as a government the more you have to sell that debt and the less attractive your currency seems."

What is the economics behind this?

1. Increased government borrowing is not going to cause a run on the Pound. UK public sector debt is 43% of GDP. Arguably this underestimates national debt because government exclude PFI. But, even so, it compares favourable with

• US national debt $10 trillion - 72% of GDP
• Italy national debt - 107% of GDP
• Japan national debt - 194% of GDP
• National debt by country
  

If the government were to borrow an extra £10billion to fund tax cuts, it may cause a rise in national debt from 43% to 44% of GDP, but, it is hardly going to cause a collapse in Sterling. (interestingly many councils burned by the Icelandic bank collapse are going to the UK debt management office to buy government bonds)

2. He suggests higher borrowing could push up long term interest rates (financial crowding out). This is certainly possible. But, higher interest rates would make demand for sterling stronger, not weaker. Higher rates may be damaging for economic growth, but, not sterling. Anyway I doubt interest rates would rise that much from a temporary increase in borrowing. Interest rates in Japan and US are low despite much higher levels of borrowing.

3. You could argue higher borrowing is inflationary, especially if Government started to print money. But, the MPC forecast inflation could fall below 1% in 2009, so this is not a real concern at the moment.

4. You could argue tax cuts are ineffective in boosting spending and economic growth. Many economists would support this. But, being ineffective doesn't mean there will be a run on the pound.

5. The fall in the value of the Pound e.g. 25% fall against dollar reflects

• a more realistic long term value. At $2 to £1, the £ was really overvalued making American goods ridiculously cheap.
• Sharp decline in UK interest rates and prospects of more rate cuts to come.
  

6. The UK economy has declined sharply in past few months leading to the interest rate cuts. But, now our competitors are not doing as badly as us. e.g. Germany announced this week it was entering recession. Because of this, I can't see the Pound continuing to fall in 2009.

I feel the shadow chancellor is using rather sloppy economics. He could criticise the government for borrowing too much in the boom. He can criticise the tax cuts as ineffective. But, to claim that modest tax cuts will cause a run on sterling, sounds as if he is searching for arresting sound bites rather than offering a reasoned understanding of the economy.

See also: The economics of tax cuts

The Falling Pound and Buying Llandudno Pier

Some recent links from my blog dedicated to readers questions and other links from around the web.

• The Pound Sterling has fallen dramatically since this summer. The pound has fallen over 25% against the dollar and nearly 15% against the Euro. A reader asks about whether the prospect of deflation causes a lower pound
• Pound Sinks to record low at Independent
• A popular question recently has been - why is dollar increasing despite economic difficulties in the US - basically, other countries are doing badly too and people are selling investments in emerging economies causing rise in dollar.
• What is Purpose of IMF in financial Crisis? - IMF have already put together rescue packages for countries like Iceland. IMF role has been highly controversial
• Relationship between Interest rates and inflation focusing on New Zealand
• The Gap between Base Rates and Bank Rates
  

Video Posts

• Should University be free? - I don't think so. But, I don't agree that the UK should send 50% of students to have 3-4 years of expensive university education

Funny

The Economist ponders the Maldives decision to buy land abroad for when global warming overwhelms their island nation.

"....It’s a buyer’s market in property these days; and, if the Maldivians are looking for an island, Iceland is said to be going cheap. But they may be spoilt for choice: think of all the tiresome bits of territory that other countries would like to offload. The snooty English, for instance, have long disparaged Wales, which they caricature unfairly as being populated mostly by Methodist preachers and disaffected sheep. It might be a challenge to persuade the Maldivians to swap their palm-fringed paradise for Llandudno pier on a wet Sunday afternoon; still, a bit of adroit marketing, focusing on the height of the hills, Catherine Zeta-Jones and Anthony Hopkins (both sadly no longer resident) might do the trick....." (Economist)

Recession Proof Jobs

Unemployment in the UK and US is rising very sharply.

• US unemployment has reached a 14 year high of 6.5%
• Yesterday, 4,000 jobs were lost in the UK alone; many fear unemployment could rise to 2 million by the end of the year, with further rises in 2009. [UK Unemployment]
  

What Kind of Jobs are Safe in a Recession?

• Economists - There is always a demand for economists to explain why we got into this mess (even if Economists mostly failed to predict it)
• Sheep Shearer. Sheep Shearing is the number one on the UK's list of shortage occupations for our new immigration rules. [link] If you hold a British Wool Marketing Board bronze medal for Sheep Shearing, this recession will easily pass you by.
• Other shortage occupations include: ballet-dancers, horse-trainers, geologists, petrophysicists, high integrity pipe-welders and chefs. I can just see all those hedge fund managers retraining as chefs, horse-trainers and ballet dancers.
• Traffic Wardens. Alas parking tickets are not subject to cyclical fluctuations.
  
• Teachers / Health Sector
• Sales Representatives. This might sound strange, but, in a recession companies put more emphasis on sales techniques to try and get those extra sales and pull the company through
• Accountants. In a recession, you still need to do your books and fill in your tax returns. Often companies hire special accountants - to increase efficiency, which is invariably a metaphor for 'restructuring the workforce'
  

What Kind of Industries Benefit from A Recession?

• Gambling / Pubs / Light Entertainment. It is suggested in a recession, people look for light distractions such as going to the pub. People don't spend on big ticket items like foreign holidays, but they will go down their local to drown their sorrows.
• Thrift Shops / Pawnbrokers. Marks and Spencers food department is struggling in the current recession. But, well known value supermarkets like Netto and Aldi are booming
• Domestic Tourist Industry. Rather than fly off to exotic locations, people may look to local tourist destinations.
  
• Some people even argue recessions are beneficial (although I don't see their reasoning) see: Are recessions beneficial

How To Survive a Recession

Although we make light of the shortage of sheep shearers, losing your job is one of the most stressful events in our life. (more stressful than divorce) These are 2 articles offering practical advice for surviving a recession.

• 10 Tips for Surviving a recession
• How To Survive a Recession
  

The Economics of Tax Cuts

In the political world, we often hear a clamour for tax cuts. Tax cuts are often presented as a solution to many economic problems, and of course, they are popular with the electorate. But, what is the economics behind tax cuts. Will tax cuts really boost economic growth? will tax cuts boost productivity?

Tax Cuts and Aggregate Demand

It is often argued tax cuts will boost spending and help recover from recession. If you cut income tax, people see an increase in disposable income and therefore, in theory spend more.

But, how much will spending actually increase?

• If confidence is low. If people want to increase their savings, (this usually occurs in a recession when people fear unemployment) then tax cuts may not be spent but saved.
• Depends on Tax Cuts. People on low income have a higher propensity to consume. If you cut taxes for those on low incomes there will be a bigger impact on increasing spending. If you cut taxes for high income earners, a higher % will be saved.
• Borrowing could cause crowding out. Ultimately tax cuts have to be paid for. In the short term, it requires higher government borrowing. Some argue that if the government borrow, the private sector buy more government bonds and so have less to spend and invest. Therefore, the tax cuts could be outweighed by a decline in private sector investment. Furthermore, increases in national debt, can push up interest rates as the government need to attract more people to buy bonds.
• The problem with cutting taxes to boost demand is that politicians 'forget' to reverse them during an economic boom. This is why the US national debt has passed $10 trillion. In a recession, there is always a call for tax cuts to boost the economy. But, as the economy grows quickly, there is no call to increase taxes, to reduce debt and stabilise growth.
• Tax cuts will help to increase growth a little, but, direct government spending on public works will have a greater impact on boosting aggregate demand.
• It does makes sense to cut taxes in a recession, as long as you increase them in a boom. The problem is that because national debt is already high in UK and US, there is little room for future tax cuts.
• There is a debate at the moment whether Gordon Brown is right to cut taxes and borrow more to stimulate the economy - see: Tax cuts now could mean tax increases tomorrow at independent
  

Do Tax Cuts Increase Productivity?

• The famous Laffer curve suggested tax cuts will increase productivity and could even increase tax revenue. The simple argument is that lower income tax increases the incentive to work.
• However, in economics there is both a substitution and income effect. To simplify. If you have a target income of £30,000. a tax cuts means that you can get this income by working less hours. Therefore, this income effect outweighs the substitution effect.
• Basically, studies show that cutting income tax rates in the US, had little if any impact on increasing labour productivity.
• However, if income tax rates were 50 or 60% then there there is likely to be a disincentive effect. But, cutting tax rates from 22% to 21% will have little impact.

Do tax cuts make us better off?

America has lower income tax than Europe. But, Americans have additional expenses in the form of private health insurance. Lower taxes are a false economy if you then have to spend more on private health care and higher education e.t.c

Should Banks cut Mortgage Rates?

Following the Bank of England's decision to cut interest rates by 1.5%, there was a predictable cry for the 'greedy banks' to pass on the full rate cuts to consumers. The shrill cry came from both politicians and the popular press. But, should banks really be returning to 2006-07 lending standards?

Gap between Base Rates and Libor rates (base rates now 3%. libor rates 4.5%)

• The bank of England doesn't control interest rates in the economy. It only controls the base rate (the rate at which commercial banks need to borrow from Bank of England.)
• The Bank of England hope that changing base rates will affect all interest rates, but, often this doesn't happen.
• The libor rate is the interbank lending rate and is important for determining actual commercial rates.

In current times, it is hard to have much sympathy for banks (it is hard to have sympathy for banks at the best of times to be honest). Anyway, the point is here the banks may have a point.

In the boom years of 2006-07, the mortgage industry became very competitive. Banks cut their profit margins in a bid to attract custom. Banks offered a wide range of mortgages to attract new customers - the 100% mortgages, mortgages 5 times salary e.t.c. By the end of 2007, the margin between bank base rates and commercial bank lending rates was at an all time low. But, banks had overstretched themselves. By lending too freely, banks like the Northern Rock and HBOS had left themselves open to liquidity problems when conditions deteriorated.

• What banks are trying to do now, is to effectively 'clean up their mess' They want to attract savings and reduce their lending to improve their balance sheets.
• This need to improve their balance sheets is even more important with the drastic decline in house prices which is leaving many homeowners with negative equity and making banks more vulnerable to repossession.

With the current perilous state of the banking system, the last thing banks want to do is to return to 2007 lending standards - lending which helped fuel an unsustainable boom in house prices.

However, bear in mind

1. Banks can reduce their standard variable rates but still increase their profit margins. (basically there will be less 'special offers on mortgages' see: how banks will avoid making mortgages cheaper.

2. Politicians are not calling for a return to 100% mortgages and lending 7 times income, just reducing interest payments for those with existing mortgages - this will help avoid mortgage defaults.

3. The libor interbank lending rate is falling to 4.5%, making it harder for banks to avoid cutting rates. (although the gap is still high at 150 base points)

4. In 2009, Lower interest rates will not fuel an inflationary boom in house prices. Lower interest rates will merely help to stabilise falling house prices. When the housing market and economy recovers, of course these interest rate cuts may need to be reversed.

5. The gap between base rates and bank rates is now the biggest since the second world war. Telegraph

• The Case for lower interest rates
• Problems with UK Housing Market
  

Criticism of the IMF

The IMF plays an important role in trying to alleviate and stabilise financial crisis. However, its role has come under intense scrutiny and it has been criticised for variety of reasons and from a range of different sources. These are some of the main criticisms of the IMF:

1. Exacerbates Economic Problems. It is argued that the conditions of IMF loans cause more harm than good. In the Asian Crisis of 1997, many criticise the IMF's insistence on deflationary fiscal policy (Spending cuts and tax rises) and higher interest rates. It is argued the IMF turned a minor financial crisis into a major economic recession with unemployment rates in countries like Thailand, Indonesia and Malaysia shooting up. Chief economist of the World Bank, Joseph Stiglitz, was particularly scathing in the IMF's insistence on high interest rates as Thailand entered recession. (IMF criticised)

2. One Size Fits All. The IMF frequently argues for the same economic policies regardless of the situation. For example, devaluation of the exchange rate may help many countries, but, it doesn't mean that this is always the solution. Policies of privatisation and deregulation may work better in developed countries in the West, but, maybe more difficult to implement in the developing world.

3. Decline in Public Services Arguably the insistence on Spending cuts (fiscal responsibility) lead to decline in public services. One report suggests the IMF spending cuts are responsible for a resurgence of health problems amongst countries which received aid. (IMF linked to higher tuberculosis rates) (IMF linked to Cholera). The IMF is frequently criticised for ignoring the impact of its policies on the poor, concentrating only on macro economic data

3. Takes away political autonomy. Countries such as Jamaica, argue that the IMF take away the ability for countries to decide national policy. Instead they have to follow the economic dictates of an unelected body, with a perspective skewed by free market ideology and the interests of the developed world.

4. Moral Hazard. The IMF has also been criticised by free market economists arguing that they do to much. They argue that intervention creates moral hazard (encourages countries to be reckless because they can rely on IMF loans) The intervention is often based on poor information and fails to deal with the economic problems. It is argued that rather than the IMF, countries should take personal responsibility.


I have to say there are many more criticisms of the IMF than this. The IMF have been criticised for just about everything from supporting right wing dictatorships, facilitating corruption (e.g. Kenya in the 1980s) to encouraging the destruction of the environment and the culture of indigenous people.

IMF - Saint or Sinner?

The reality is something in between. At times they have appeared rather inflexible insisting on fiscal responsibility and privatisation at a time which might not be helpful for the economy. The criticism of exacerbating the Asian crisis has a strong argument.

But, at the same time, it must be remembered, people call on the IMF in times of crisis. When you have a balance of payments crisis, depreciating exchange rate, there is no easy painless fix. Whatever the IMF recommend people would use it as a convenient point of blame. It is hardly surprising governments do blame an external body like the IMF, it helps to deflect criticism from the government and why the economy ended up needing a bailout.

This does not mean that the IMF are blameless, far from it. They have made many mistakes and errors of policy. But, they have been criticised for both doing too much and also doing too little. They have accused of being free market ideologues but also have been accused of interfering too much with free market mechanisms.

The problem the IMF face at the moment, is that they simply don't have the necessary funds to bailout the amount of debt in emerging economies. The President of Pakistan has complained that the current response of the IMF has been tardy and too slow (link) It may require greater intervention from member states such as the US, gulf states and the European Union. If the intervention is carefully managed, then short term loans may mitigate some of the worst effects of the current financial crisis.

• Role of IMF
• Advantages of IMF
  

IMF - Advantages and Disadvantages

With economies around the world on the verge of collapsing. Some are pointing to the IMF as a potential saviour of the world economy. They argue that the IMF can play a key role in avoiding financial crisis and restoring confidence to a battered international economy. Yet, at the same time many view the IMF with disdain, arguing that their intervention causes more problems than it solves. (see: Criticism of IMF)

• What does the IMF actually do? and Why is its role so Controversial.

The IMF was founded in 1944, to facilitate the post war economic recovery. In particular the IMF was to play a role in stabilising exchange rates and balance of payments, whilst its sister organisation the World Bank would provide loans for long term development.These days the IMF plays a role in:

• Compiling statistics and evaluation of its member countries economies (Nearly all in UN are members of IMF)
• Intervening in Financial crisis to provide loans and conditions for restructuring the economy to avoid future crisis. In recent months this has involved
• $2.1 billion to Iceland
• $15 billion to Hungary
• $16 billion to Ukraine
• An emerging markets fund of $200bn to stabilise financial systems.
  

Advantages of the IMF.

• IMF can be seen as lender of last resort. When a country is seeing an exodus of currency due to a balance of payments crisis, the IMF can provide crucial loans to stabilise the economy and prevent a collapse of confidence.e.g. Recent loans to:
• Supporters argue that the IMF can also impose necessary reforms on an economy. Reforms such as privatisation, fiscal responsibility, control of Money supply, and attacking corruption. These policies may cause short term pain, but, are essential for preventing future crisis and long term development.
• Provides an external assessment of the economy, which helps the government to implement popular ideas.

Yet, despite the potential benefits of having a monetary fund which can provide an effective counter to financial crisis, the role of the IMF has proved very controversial.
It's critics argue the IMF is dominated by the perspective of the G8 industrialised nations. They argue the IMF insists on blanket policies of structural adjustment which may actually harm the economies they are intervening. See: Criticisms of IMF

Yet, whilst it is easy to criticise the doctor which prescribes a bitter pill, there is a consensus that, now more than ever, we need an effective international organisation which can deal with the many financial crisis that are occurring around the world.

Government Borrowing In Recessions

In recessions, government borrowing will increase. This is because:

• Higher unemployment means less people will be paying income tax
• Lower consumption levels mean lower VAT and excise duties.
• Lower company profits mean lower corporation tax
• Higher unemployment increases cost of social security payments - unemployment benefit, income support, housing benefit e.t.c
• Falling house and asset prices reduce stamp duties
  

In this current recession, the impact on tax revenues is even greater. In the UK the top 1% of income earners pay nearly 25% of total income tax revenues. Therefore, the decline in executive bonuses for bankers and hedge fund managers means tax revenues are falling more than usual.

Furthermore, in a recession, government often try to stimulate the economy using expansionary fiscal policy. This could involve:

• Cutting taxes so people (hopefully) spend more
• Increasing public sector spending to stimulate aggregate demand

National Debt in Recessions

In a recession, not only will national debt increase, but as % of GDP, national debt will become higher. This is because the government borrow more, but GDP is decreasing. During economic growth of 3%, the government can borrow 1% of GDP, and National debt as a % of GDP falls

Should We Worry about Government Borrowing in a Recession?

• Apart from the most hardline neo-classical economist, most economists would say that a rise in government borrowing in a recession, is unwelcome but necessary.
• To balance the budget would cause a much deeper recession. If the government tried to balance the budget through higher taxes and cuts in public spending it would cause a bigger fall in GDP and lead to even lower tax receipts.
• However this is what the UK did in 1930, exacerbating the Great Depression (unemployment benefits were cut and taxes raised on the advice of 'treasury economists'
• Mrs Thatcher also did this in the 1981 recession, making the recession much deeper than necessary.
• By borrowing more the government is trying to increase aggregate demand and economic growth. The hope is by preventing a deep recession, they will get better tax revenues in the future.
  
• The key thing is that this cyclical deficit should prove temporary. This is different to a structural deficit (when the government is borrowing even with high growth)
  

Problems of borrowing

• May cause crowding out. Government borrow from private sector so private sector have less to spend. Therefore, demand doesn't increase -
• If government cut taxes in a recession, then they need to raise them when the economy recovers and starts to grow. The problem is politicians forget to do this. Its easy to cut taxes, but, then they don't want to reverse the tax cuts or spending increases in times of a boom.
• If National debt becomes unmanageable, it may cause interest rates to rise, or if the Central bank starts printing money inflation could occur.
• Will require higher tax rates in the future.
  

But, bear in mind, Japan has been coping with national debt of 190% of GDP. The UK had a national debt of over 125% in the late 1940s and survived. UK National debt is (only) 43% of GDP. US National debt is closer to 70% of GDP.

Suffice to say, Government borrowing is not the biggest concern during a recession.

Obama Economics

One of the amusing things about the American election, was seeing a Republican support ask the Obama team whether Obama was a Marxist.

However, vague Obama might have been in his campaign speeches, I never heard a plan to take private enterprise into common ownership and redistribute 'to each according to his need'. Whatever Marx might have said about Marxism, I'm sure it wouldn't have included voting for a $700bn bailout for banks so they could sell useless junk bonds and continue to pay executive bonuses.

I'm not sure why Americans have such a paranoia about Marxism, anyway let us not get distracted by political philosophy. The interesting question is what does Obama stand for? What kind of economic policies can we expect?

I took many of these policies from Obamanomics by John R.Talbott. It reads a little like a extended election manifesto, nevertheless it is detailed in a way Obama's speeches aren't.

Obama's Economic Policies.

1. An End to 'Trickle Down Economics' - In reality trickle down economics is a very loose term to describe the idea that any wealth created will benefit the whole of society. Trickle down economics can be used to justify tax cuts for the rich, privatisation, and free market economics. Obama is likely to use the tax system to redistribute income in a more progressive way. This will be reversing the tax cuts of the Reagan and Bush years, which favoured high earners.

2. Closer Regulation of financial system. The current financial crisis has illustrated the failings of unbridled free markets. The climate has left even free market exponents admitting the need for greater regulation of financial markets. Obama will never have a better opportunity to impose greater scrutiny on wall street, the mortgage industry and the wider financial sector.

Other specific policies:

• Increase the Minimum Wage. The US Minimum wage stayed constant for over 10 years before a Democratic congress increased min wage to $7.25, it means its real value has declined increasing relative poverty for the low paid. This level is still lower than the real value of 1968. The UK experience suggests increasing minimum wage did not cause unemployment
• Retain inheritance Tax. Many wanted inheritance tax, but, Obama will keep it and possibly reduce tax threshold
• Income Support Extend income support for low paid workers
• Extend number of statutory sick pay to 7 days.
• Child Care Expand Child care support tax credits.
• Unions. Greater Support for workers right to join a trade Union.
• Education. Greater spending on education, such as preschool education, after school education programmes.
  

Financial Sector

• Cut extravagant interest rates for payday loans
• Greater regulation of mortgage industry. e.g. closing loophole to allow bankruptcy courts to change the individual's mortgage payments.

Global Warming

Push through legislation which commits US to reducing global carbon emissions. He is likely to face fierce lobbying from US oil and manufacturing interests.Policies includes:

1. Market based cap and trade system to limit emissions
2. Emphasise energy efficiency, conservation and development of alternatives.

Trade

Whilst Obama has stated free trade and globalisation are here to stay. He has also talked at how American workers have lost out due to globalisation. His rhetoric suggests he would contemplate intervention in the form of tariffs and subsidy to help declining American industries, struggling to compete with Asian economies.

Health Care

Extend health care provision to include all uninsured. But, not attempting to replicate the simpler systems in Europe of free at the point of use.

Personally, I like the shift towards greater redistribution. But, Economists may be concerned about:

• The prospects of tariff protection for America's declining industries. It may be populist, but, government intervention will not be able to stop the changing comparative advantage of international trade.
• Greater Labour Market Protection will help low paid workers, but, with unemployment rising, the additional costs for business may lead to further unemployment. However, given the lack of current labour market protection, the impact on job losses maybe muted. It is not implementing a French style maximum working week e.t.c
• National Debt. Obama's plans to spend on health care and education are laudable, but, with National debt increasing to over 70%, he might struggle to find the money to finance ambitious spending plans.
• Higher taxes may reduce incentive to work. However, when they were cut, they never caused a productivity boost, many claimed it would.
  
• It is also dissapointing that it is too politically difficult to get rid of the complicated layers of bureaucracy endemic in the US health care. His policies are tinkering at the edge without removing the powerful vested interests of health insurance companies.
• Regulating Financial Markets sounds common sense. But, in practise it is much more difficult that people imagine. It wasn't just free markets who caused the subprime crisis. It was also government policy which encouraged Freddie Mac and Fannie Mae to lend to all and sundry.
• The fundamental problem is that the economy is facing a serious recession and there is going to be no quick fix. - Problems Obama will face.
  

This is a long post, without satisfactorily doing justice to the many issues. It will be interesting to see what actually happens.

• Obama Economics at Amazon.co.uk

Drastic Measures for Desperate Times

The Bank of England were widely expected to cut interest rates today. But, the decision to cut rates by 1.5% 150 basis points, took many by surprise. It is what the economy needs (see: why interest rates need to be cut), and in a way makes more sense than cutting rates by 0.5% for the next 3 consecutive months.

As if to confirm the Bank of England's decision to cut rates, house prices fell by a huge 2.2% in October. It means UK house prices have fallen to 2005 Levels

Talk about a rollercoaster - This graph of UK House prices would give anyone Vertigo


What will Happen now?

• Banks are unlikely to pass the full 1.5% cut onto consumers, but, they will have to pass, at least some of it on.
  
• Lower interest rates should help those who are struggling with mortgage payments. It will limit home repossession.
• It may encourage higher consumption and investment, or at least it may moderate the falls in consumption and moderate the rise in unemployment.
• The Pound will be weaker as the UK is less attractive to save money
• Savers are worse off.

However, the huge interest rate cut will not solve the underlying problems; the economy still has several months of slow / falling growth to anticipate.

See also: Video discussing different Policy Options for Economies in recession (posted today)

Outlook for Japanese Yen

To understand the outlook for the Yen and its impact on the global economy, it is important to understand some background to the Yen and Japanese economy.

1. For several years Japan has had 0% interest rates. Recently they were increased to 0.5% but, they are much lower than other economies. For example, ECB have had interest rates of 3.5-5%
2. Japan has very high levels of savings - a pool of $15,000bn. This pool of savings is worth more than the total GDP of the US economy. Japan's excessive saving contrasts with the excessive spending and borrowing of the US.
3. Because interest rates in Japan are very low. Japanese investors have been investing oversees. Why save in a Japanese bank and get 0% interest when you could save in Australia and get 6% or Europe and get 4%? Japan has accumulate $6 trillion of foreign assets. As they buy foreign assets it increases the value of foreign currencies such as dollar
   
4. Also many Foreign investors, especially American have borrowed in Yen to invest in global stock markets. This is known as the Yen Carry Trade.
5. The Yen Carry trade is profitable if currencies are stable and / or the dollar is rising against the Yen. If you borrow in Yen and then the dollar falls, you could lose despite the interest rate difference.

Global Recession.

Recently the global economy has been entering a recession. This means interest rates are falling and are predicted to fall in Europe, America and other countries affected by slowdown. This means that the difference in interest rates between Japan and the rest of the world is narrowing. There is no longer the same incentive to borrow Yen and invest oversees.

Because US and European interest rates are low, Japanese Investors have started to sell their dollar and Euro investments and return their money to Japan. This means the Yen has been appreciating.

Graph showing Appreciating Yen and Falling Dow Jones Index



Over the past 2 months The yen is

• 36% higher against the Brazilian Real,
• 29% against the Australian Dollar,
• 33% vs. the New Zealand Kiwi,
• 16% higher vs. the British Pound,
• 18% higher against the Euro over the past nine weeks.
• The only currency to rise against the Dollar

Because the Yen is rising, the Yen Carry trade becomes unprofitable, investors could lose substantial money if the Yen rises against the dollar and Euro. Therefore, with the Yen rising, people are selling their foreign investments and ending their carry trade. This increases demand for Yen even more, causing a further rise in the Yen

The Effects of Unwinding Yen Carry Trade

1. The Japanese have an incentive to sell their foreign investments. This means selling shares. Therefore, stock markets around the world could fall as the Japanese unwind their $6,000bn foreign holdings. (Japan is by far the world's largest creditor nation.

2. As the Yen Rises, people will rush for the exits selling their foreign currency to repay their Yen loans. The rise in the Yen causes a speculative bubble causing a large rise in the Yen and fall in other countries.

3. Harms Japanese exports. A higher value of the Yen makes Japanese exports more expensive reducing demand and causing lower economic growth and possibly deflation.

4. To deal with the rising Yen and slowing economy, Japan reluctantly cut its base rate from 0.5% to 0.3%. However, there is only very limited scope for future interest rate cuts.

Forecasts for Yen

With the global economy slowing down, the Yen is likely to get stronger as investors rush to the 'safe exchange rate' of the Yen.
Currently 1 US dollar = 100 Yen. But, this could fall in 2009.

• Yen Carry Trade Explained
• Japanese Financial crisis explained
  
• Beware the unwinding Yen Carry Trade at FT
• Yen Carry Trade unwinds at Gold news
  

Policies For A Recession

What can the government and monetary authorities do in a Recession?

1. Monetary Policy

Lower interest rates usually increase consumer spending and investment.
Lower interest rates:

• reduce cost of borrowing encouraging investment
• Reduce cost of mortgage payments increasing disposable income of homeowners
• Reduce incentive to save.

It is hoped that if MPC cut rates a serious recession might be avoided. US interest rates are already 1%, it is doubtful how much effect cutting rates to 0% would actually have in stimulating economy.

What are problems of cutting rates?

• Liquidity trap. Cutting rates may not encourage people to spend if confidence is very low. e.g. loans might be cheap, but who wants to invest when economy is in recession?
• Deflation. If an economy experiences deflation, even interest rates of 0% may be ineffective. This happened to Japan in 1990s and 2000s. (see: Japanese Crisis)
  
• Will Bank Lend? The problem at the moment is that banks don't want to lend mortgages and loans because of liquidity shortages. Reducing the cost of borrowing doesn't solve this problem.
• Depreciate exchange rate. lower interest rates reduce the value of exchange rate, which could cause inflation and increase cost of imports.
  
• Savers lose out. At the moment interest rates are lower than inflation. This means many savers will see a decline in their value of savings. Low interest rates help borrowers but harm those who are saving. Nevertheless, the cost to savers is relatively small compared to the cost of a very deep recession and mass unemployment.
• Time Lag. Lower interest rates can take 18 months to have an effect.
  

2. Fiscal Policy

In theory Lower taxes and / or higher government spending should provide a boost to aggregate demand and increase economic growth.

The effectiveness of fiscal policy depends on a few factors:

• Income tax cuts may be saved. If you cut income tax for high earners they will probably save it. If you cut taxes for low income groups they will probably spend it. (poor people have a higher marginal propensity to consume)
• Borrowing must be low to start with. The problem is that governments find it easy to cut taxes. But, then in the boom years they don't increase them again. For example, Bush cut income taxes in 2001, this boosted economy. But, in boom years, these tax cuts were not reversed. Therefore, national debt increased even in times of an economic boom. It means the US has now little room for manoeuvre.
• This is not a failure of fiscal policy. It is a failure of politicians to do the other equally necessary aspect of fiscal policy which is increase taxes / cut spending in a boom.
• There will be a time lag for fiscal policy to have an effect.
  

Increased public spending. Some economists scoff at Keynesian style public works scheme. But, in a recession and mass unemployment these public work schemes can work. They get unemployed people back into work and create a multiplier effect throughout the economy.

Fiscal policy is not guaranteed to work. Japan tried to reflate the economy in the 1990s and 2000s. They were remarkably ineffective. Instead Japan has been left with a national debt approaching 190% of GDP. Many economist see this as evidence that fiscal policy is a failure. But, it is not as simple as that. In Japan everything failed - Interest rates of 0%, tax cuts. The problem is that with deflation, falling money supply, deflating asset prices ordinary policy becomes less effective. Consumers didn't want to spend the tax cuts, because prices would be lower in 12 months.

See also: Problems of Fiscal Policy
See also: Recession of 1981 - caused by tight fiscal policy.


3. Increase Money Supply

In periods of deflation, the authorities have to do something radical. They need to increase the money supply. They need to create some inflationary expectations.

The problem is that this concept is too radical for many monetary authorities to contemplate. They are so well versed in trying to control inflation, the idea of creating inflationary expectations is too much. It is hard to believe that Japan was reluctant to increase money supply, despite deflation and economic recession, because of this overwhelming fear of inflation.

• Video on Causes of Recession
• Essays on Recession