Questions on Bank Policy

Readers Question from: Gilts bought by the Bank of England

What do you think of the policy - (Gilts being bought by the Bank of England?)

Firstly, it is hard to evaluate the policy as it has not been implemented on such as a scale before. We are charting unknown territory. Also at the moment, the economy is exhibiting unusual behaviour. We are in the middle of a liquidity trap where, for example, a cut in interest rates is not stimulating demand for money. At the moment, the purchase of gilts seems to have had only a limited effect on stimulating bank lending. It appears many banks are just benefiting from selling gilts to the Bank of England. However, although the impact of the policy is so far limited, the Bank will be encouraged at the tentative signs of growth.

However, rather than buying government gilts, the Bank of England may have more impact by buying corporate bonds and increasing bank deposits of firms directly, rather than indirectly through banks.

What do you think of that (inflationary) pressure?

Quantitative easing has so far had little impact on inflationary pressure. Though the increase in the money stock sounds impressive, it has mostly been absorbed by banks in their balance sheets. Tax rises and higher oil prices may push up the CPI in 2010, but, the underlying inflation rate remains low because of the spare capacity and high levels of unemployment. At the moment, it is hard to see any inflationary risk.

And what do you think the Bank can achieve if inflation expectations remain muted?

I think the bank will want inflation expectations to remain fairly muted. Ideally, they will be targetting inflation of 2%. However, they will definitely want to avoid expectations of deflation which could cause a fall in consumer spending as people wait for prices to fall.

If inflation was too low some economists suggest you can either

• Pursue negative interest rates (charge banks for holding money or withdraw)
• Give money directly to consumers - e.g. a helicopter drop / money gift mentioned by Milton Friedman

US Debt Levels

US national debt has been rising rapidly. Since September 2007, the National Debt has continued to increase an average of $3.80 billion a day. It now stands at just under $12 trillion. In many respects the steep rise in government borrowing is a cause for major concern. Usually, higher government borrowing leads to:

• Crowding out of private sector
• Higher interest rates to attract lenders.

However, in this recession, crowding out is not occurring. As we have mentioned before, government borrowing is offsetting private sector borrowing.

This interesting graph from the New York Times looks at overall debt in the US. In 2007, total US debt (i.e. from both public and private sector) was increasing at 10% a year; in 2009, this has fallen to 3%. This is the smallest increase in total debt levels since the Fed began collecting statistics in the 1950s.

The main reason for this slowdown in overall debt accumulation is the fact that private households and firms have been seeking to pay off debts. It reflects the low confidence and change in attitudes to thrift and spending. This wasn't so much a feature of previous recessions. It reflects how much confidence was effected.

It's a similar situation in the UK where national debt is rising rapidly, but, for the first time on record UK personal debt is falling.

Forecasts for Pound Sterling in 2010

The Pound has been taking a battering in recent years, not helped by a policy of benign neglect by the Bank of England. Despite a 10% appreciation in the first half of 2009, at the end of June 2009(2) the £ERI was around 20% lower than in August 2007.

The Bank of England have suggested that they view the fall of the Pound as necessary - even beneficial. This is for two main reasons:

1. Underlying Trade Deficit. The UK has been running a persistent current account deficit (importing more good and services than exporting) for the past two decades.(UK Current account deficit) In the past, this trade deficit was financed by attracting capital flows. However, in the post credit crunch economy, these capital flows have fallen. Therefore, the fall in the exchange rate is necessary to rebalance trade. The UK is experiencing a fall in “the long-run sustainable real exchange rate”. The fall in the Pound should help exporters and reduce attractiveness of imports.
   
2. Economic Recovery. Part of the Pound Sterling's weakness is due to the perception the financial / economic crisis hit the UK harder than many of our European partners. The UK banking sector is still fragile following the credit crisis and therefore, the Pound is weak to reflect the depth of recession and the likelyhood UK interest rates will stay close to zero for a long time.

In addition to these factors, the other two factors weakening sterling are:

• Large Budget deficit. Government borrowing is at record peacetime levels. Very high levels of government borrowing can undermine confidence in a currency see: Why National Debt effects Sterling
• Quantitative Easing is being pursued in UK more actively than elsewhere. The extent of money creation is creating a fear of potential future inflation and this undermines Sterling.

These factors suggest that the Pound's current weakness could remain in the foreseeable future and even worsen.

• Close to Parity with the Euro
• £1 = $1.50

However, some such as Barclays Capital are predicting a rally in Sterling. They suggest sterling could rise against the Euro to Euro 1.25 October 2010. Against the dollar it expects a rise to $1.80.

Why Sterling Could Rise

• Weaknesses in the UK economy are matched in US and Eurozone. We are not alone in having ballooning debt and deep recession
  
• The Bank of England seems indifferent to the Pound's fall. But, it is not actively pursuing a weak pound (it also appeared indifferent at the Pound's recovery earlier in the year). It will want to maintain the credibility of UK Monetary policy and could be forced to raise rates should inflationary pressures return.
  
• If the UK does recover, interest rates could rise making sterling deposits more attractive.

Related

• Interpreting recent movements in Sterling - pdf available at Bank of England website
• Understanding exchange Rates
  

A Weak Pound and Other links

Mervyn King indicates he doesn't mind a weak pound as quantitative easing continues. - Pound falls

• How The Crisis Spread - Why defaulted subprime debt in US effected Europe and rest of world
• GDP and Happiness - Why economists say GDP is limited as a measure of economic welfare
• Baltic Dry Index explained - a leading economic indicator suggesting recovery is underway

• Why fast food restaurants give free refills of soda
• Why Water is more expensive than beer, when beer is taxed
• Difference between Monetary Policy and Fiscal Policy

• Interest rate swaps explained - how to make money if you know what's going to happen to interest rates
• Financial Conspiracies - some of the crazy conspiracies out there
• Questions on public debt
  
• Difference between recession and depression
• and Why Spain is looking like a depression
  

Gilts Bought by Bank of England

Since the policy of Quantitative Easing has been introduced this year, the composition of those holding public sector debt has changed signficantly. Typically, government debt is held by the private sector - banks, pension funds, investment trusts both domestic and from oversees.

However, by September 17th, the Bank of England had completed the purchase of £147bn of government gilts. By contrast commercial paper and corporate bonds account for just £1.8bn.
Asset Purchase facility at the Bank of England.

The Bank of England now owns 20% of the outstanding stock of nominal gilts.

It means, in recent months, the Bank of England has become the main buyer of government debt. Raising concerns that if the Bank of England stopped buying gilts or had to reverse its policy of quantitative easing - by selling gilts on open market, the government would face difficulty in selling sufficient bonds and gilts to finance its budget deficit.

Some market analysts suggest it is not as bad as it looks.

• Markets are taking advantage of the Bank of England to sell now whilst price is rising. If bank starts to sell its gilts, banks will probably be able to buy back at a profit.

However, it is an unusual situation for the Bank of England to be buying so much government gilts. As the IMF suggested, it has definitely helped reduce the yield on gilts. Without the Bank of England buying so many gilts, interest rates would be higher. This means that the cost of servicing the national debt would be higher without the Central Bank intervention.

There is also concerns about whether the purchase of gilts from banks is actually affecting the economy. In August M4 money supply growth was only 3%, -the lowest since 1999. This has led some to suggest the main beneficiary of quantitative easing is not increasing economic activity but financing government spending and government debt.

There is pressure on the Bank of England to use its asset purchase facility to buy more private sector bonds and try target private enterprise.

Related

• UK Debt Burden - historical perspective showing we have faced much worse burdens of government debt
• Graph showing main buyer of gilts in past few months has been Bank of England

Better Off on Benefits?

• The poverty trap occurs when there is no incentive to get a better paid job because of the lost benefits, and increased taxes and other costs.
• The unemployment trap occurs when there is no incentive to get a job because, you are better off on unemployment benefits than working.

Reading our local newspaper, the Oxford Mail, I was intrigued about their story suggesting many single mothers said there was no point for them to get a job. Quite a few people interviewed said, they would like to work, but, if they did they would be worse off because of the lost benefits and extra costs involved.

For example, one mother said that currently she received £70 a week benefits (£40 of income support and £30 child tax credit. She is also exempt from paying council tax (about £800 a month) and her rent of £75 a week is paid for her. In addition their are many benefits in kind for people on income support (free prescriptions).

If you include the free rent, the government is paying over £150 a week and is missing out on the work related taxes.

Another mother, Nickki Green, a mother of two said:

"I left work, because you get more help with child tax credits than I could have earned in a week's wages as a nursery nurse. It's ridiculous if you think about it."

The thinktank the Centre for Social Justice suggests many claimants taking a job paying less than £15,000 a year were worse off than if they remained out of work.

The DWP have started a campaign to show people they are better off working. They also emphasise that working has other benefits such as promoting self-confidence and being good for mental and physical health.

The budget for social security is by far the largest component of government spending.
It is over £170bn and forecast to top £200bn in 2010.

Interest Rate Forecasts 2010 and Beyond

Readers Question: Where can I find a reliable forecast of interest rates over the next 5 years. I have seen wild claims of everything from a minus figure in 2010 to 15%. I am interested in likely mortgage rates. Is it likely that interest rates could rise by 1% a year over the next 5 years?

Predicting interest rates is difficult. At the start of 2008, when interest rates were 5%, and inflation was above the governments inflation target, how many people would have predicted within 12 months, interest rates would have fallen to 0.5%?

Like many economic factors, interest rate forecasts are more likely to be accurate in the short term than the long term. I think most economists would be reluctant to forecast interest rates more than 1 or 2 years in advance. To predict interest rates in 5 years time, you might as well throw a couple of dice - hence the variety of interest rate forecasts you may have come across. In fact many economists are reluctant to get into forecasting because you are dealing with so many unknown and unpredictable factors.

It is quite possible interest rates will stay at 0% during 2010. Consider these factors:

• Recession deepest for a while. Output has fallen 6%, leaving a large amount of spare capacity
• Continued rise in unemployment will depress wages, inflation and consumer spending.
• Banks and consumers are seeking to pay off the 'hangover' of a decade of debt. Hence, we expect saving rates to continue to rise.
• The evidence of Japan suggests that when an asset bubble bursts, the economy can be stuck in a period of stagflation for several years. Although UK house prices have stabilised in recent months, they still look overvalued on long term price / earnings ratios. Therefore, with wealth declining consumers will be reluctant / unable to spend and this causes sluggish growth or even a double dip recession.
• As long as growth is well below the trend rate of 2%, inflationary pressures will be absent and the Bank could keep interest rates low.
• The government will probably have to raise taxes / cut spending. This deflationary fiscal policy will enable monetary policy to stay loose (interest rates low)
  

Why Do Some People Forecast a Sharp Rise in Interest rates?

You could say that the economy is due to bounce back from the recession. Furthermore, the combination of :

• Increasing money supply through quantitative easing
• Large fiscal deficit
• Depreciation in Pound

All create inflationary pressure. Especially through increasing money supply, the Bank could be creating substantial inflationary pressure in the medium term. Therefore, as inflation picks up, the bank will be forced to raise interest rates to prevent this inflation.

My Opinion

At the moment, I can't see anything in the economy which suggests a return of inflationary pressures. The CPI measure of inflation continues to fall to 1.6% - below the governments target. Unemployment continues to rise and the most striking feature of the economy is one of spare capacity and more bad news to come.

This is not to say, inflation and interest rates couldn't rise sometime in 2010 and 2011. As the depth of the recession took us by surprise, the recovery could return quicker and stronger than we expect. But, at the moment, I can't see that.

The graph on this page - interest rate predictions show that in August, the mean expectation was for rates to be around 4% in 2012. But, you always have to bear in mind this is a guess as much as a prediction.

If I was a homeowner taking out a mortgage, I would want to be budgeting for a rise in interest rates to 5-6%. In the foreseeable future, I can't see interest rates rising above 5%. But, in economics the 'foreseeable future' may not be very long at all!

At the end of the day, if you really could accurately predict interest rates (unlike the rest of the market professionals), you would be able to make a lot of money on the interest rate swap market.

The Problem With Saving

As many taxi drivers will tell you, the problem with the economy is we got ourselves into too much debt. - Too much personal debt, too much corporate debt and too much government debt.
So since debt is such an intrinsic part of the current crisis, it is perhaps counter intuitive to explain why debt is not always bad and a rise in savings may create problems as well as benefits.

Source: B of E quarterly report 2009 (web link)

As this graph shows, saving ratios fell since 1995. Even adjusted for inflation, the saving ratio fell to record levels in 2008. The graph also shows the decline in personal wealth - mostly linked to falling house prices and to a lesser extent falling stock markets.

However, the factors that caused a fall in the savings ratio have been reversed and the savings ratio is likely to rise sharply over the next few months / years.

These factors include:

• Greater uncertainty over unemployment. Fear of unemployment encourages people to save as a precautionary measure
• Lower asset value. The fall in house prices since 2007, increases the incentive to save. Generally, when wealth rises people feel more confident to spend and borrow against the value of their house.
• Tougher Credit conditions. Banks are less willing to lend and stricter about lending mortgages.
• Expectation of higher taxes in the future to reduce government borrowing.
  

One factor that caused a fall in the savings ratio in the mid 2000s is a low real interest rate. At the moment, this is one factor that shouldn't be encouraging a rise in savings. With interest rates at 0.5% and CPI inflation at 1.6%, the interest rate gives little incentive to save.

The concern the Bank of England has is that households could reduce their consumption too much. Consumption accounts for 75% of aggregate demand, a general rise in saving against a backdrop of stagnant real wages, could keep the economy stagnating for many months. A weak recovery would mean tax revenues struggle to pick up.

Monetary policy and fiscal policy will not be trying to prevent a rise in savings and the paying down of debt. But, it will try to smooth the readjustment so the correction to long term saving rates isn't too sharp when the economy is at its most vulnerable.

• The new Frugality

Rise In Youth Unemployment

The first signs of economic recovery are welcome, but, it can't hide the fact there is a huge amount off spare capacity in the economy. And perhaps the worst feature of this recession is the sharp rise in youth unemployment. Statistics suggest 1 in 5 of 16-24 year olds are unemployed. The number of jobless in this age group rose from 928,000 to 947,000. (link)

It suggests that unemployment is worse than official figures suggest. Using the claimant count method we have an unemployment rate of 8%. But, this hides the people who are economically inactive but not counted as unemployed. It may also reflect demographic changes that are causing a shrinking working population at the older age group.

Total unemployment rose 210,000 to 2.47m in the three months to July, taking the jobless rate to 7.9% as measured by the claimant count.

Related

• UK Unemployment rate
• Unemployment in the UK

US China Economic Relations

The relationship between China and the US reminds you of a couple permanently squabbling with each other - but no matter how much they find fault with their partner, they know they couldn't live without each other.

China and US is a classic love hate relationship. It is an intriguing example of how economic ties can bind in a way that political ideology never could.

Statistics for US China Economic Relations.

• The US has a large trade deficit with China. In 2008, it stood at $268 billion. (US trade deficit stats)
  
• For every $1 China spends on US goods, US citizens spend $4.46 in China.
• Exports to the United States account for 6 percent of China’s entire economic output.
  
• US exports to China account for 0.5% of US GDP. In a trade war, there would be one clear loser. (China US trade at NY Times)
  
• Because of this large trade surplus China has substantial foreign currency reserves. With these foreign currency reserves, China has accumulated $2 trillion in foreign reserves, mostly in Treasury bonds (government debt) and other dollar-denominated assets

China keeps buying US assets for two reasons.

1. Buying US bonds keeps the Chinese currency, the Renminbi, undervalued. This makes Chinese exports more competitive and helps boost Chinese growth.
2. The Chinese have so many US assets they don't want to see them devalued. In a perverse way, the Chinese have a vested interest in the value of the dollar. Also they need a strong US economy so US consumers will keep buying its goods.

Why China needs the US

China needs the US to keep buying its goods. Without US demand, Chinese exports would fall and the economy would suffer. With unemployment high and social instability increasing, this is something the Chinese government don't want.

Why US needs China

The US need the China, for cheap goods, cheap components and perhaps more importantly for their holdings of US Treasury debt. With the US national debt edging towards 80% of GDP, China remains an important player in buying US debt and keeping US solvent. Forecasts for future US national debt mean this will be a key issue for the US.

Political Reality and Economy Reality.

Both governments face a population which takes a much more nationalistic view of events.

Chinese bloggers are criticising the fact China buys so much US debt and then the US place tariffs on Chinese goods like tyres.

In the US, there is a similar protectionist strand. For a long time, a cross party spectrum (though mostly on the right) have held up China as a major cause of declining US manufacturing. They argue the trade deficit with China is a reflection of an unfair exchange rate and unfair competition. Just recently the Obama administration bowed to this popular sentiment in putting tariffs on some Chinese imports.

It is a dilemma for both governments. China is actually sensitive to their citizens anti American feeling and implicit criticism of Chinese policy. Yet, at the same time, they have to walk that difficult tightrope. - They may not like what the US is doing, they may even regret buying all the US debt. But, they don't like the alternative either. The Chinese government knows it needs the US to keep buying its goods - it couldn't afford a collapse in the dollar.

It is maybe true the Chinese could cause very serious problems for the US economy by selling all its US debt. But, paradoxically, China knows that causing major problems for the US would only cause itself major problems.

China will probably keeping buying US debt. Not out of altruistic desire to help an old friend of course! But because it is reluctant to give up its weak Renminbi policy.

The US will put up a few high profile tariffs to appease protectionist sentiment. But, both countries know they cannot afford a full blown trade war. But, as is always possible, political nationalism may triumph over economic sense.

Related

• US National Debt
• US trade deficit with China
• Why is Chinese Currency Undervalued
  

Bank of England's Interest Rate Decisions

The Bank of England have responsibility for setting interest rates. There is a brief overview of how they set interest rates here.

Since the Bank of England was made independent, in theory, there is greater transparency with the Bank of England publishing the minutes of minutes into deciding interest rates.

But, behind the closed doors, recent revelations suggest it is not just a polite gentleman's club. According to David Blanchflower, a former member of the MPC, a divisive battle was played out before the Bank's dramatic decision to cut interest rates by 1.5% in November. (see: New Statesman)

David Blanchflower was critical of the Banks model of deciding interest rates and predicting the state of the economy. He argues the Bank relied too much on theoretical models which came to place an unwarranted emphasis on the risks of inflation and underestimated the growing evidence of recession and financial crisis.
"I focused on the

empirical data suggesting Britain was heading for recession; Mervyn and the rest of the committee focused on their theoretical models and the (invisible) threat of inflation. In fact, the Bank of England may more suitably be called "the Bank of Economic Theory". Unfortunately, the economic theories failed just when we needed them most."

Eventually, David Blanchflower had his way and the Bank cut interest rates dramatically. However, he argues that if the Bank had cut interest rates earlier, the impact of the recession may have lessened.

It highlights another example of the limitation of relying on economic theory and models. see: Failure of economics.

• Bank of England interest rates

Financial Meltdown History

A year ago, the US investment bank, Lehman Brothers went bankrupt. After helping to bailout Bear Sterns, the mortgage giants - Freddie Mac and Fannie Mae, and other banks, the US monetary authorities felt they had to draw a line in the sand and let banks face up to the consequences of their reckless behaviour and poor decisions.

The impact of allowing Lehman Brothers (with a a balance sheet of $600bn) to go bankrupt was to create a firestorm of financial panic, which threatened to engulf the whole financial system.

Why Did Lehman's Bankruptcy Cause So Many Problems?

Lehman were involved in underwriting other bank and company loans. Many people who had been dealing with another company were taken aback to find the bankruptcy of Lehman left them out of pocket even though they had not directly dealt with them.

Until Lehman went Bankrupt, the markets implicity believed that no big bank would go bankrupt. Banks were a safe investment, because markets felt banks wouldn't go bankrupt. The failure of Lehman caused markets to re-evaluate their assessment and risk of other financial bodies. If Lehman was allowed to go bankrupt, suddenly many other banks looked very vulnerable and markets needed to reprice their evaluation of banks.

Given the market fall out from Lehman's bankruptcy, governmentw soon realised they simply couldn't afford to let other banks go bankrupt. If they did there could be an unstoppable wave of financial panic leading to a great depression like in the 1930s. Therefore, in quick succession, governments on both sides of the Atlantic were forced to intervene nationalising banks or facilitate the rescue of former banking giants.

The cost of the subsequent bailout has topped over $9,000bn. This is the scale of intervention in banks that was required to restore confidence.

The Treasury hoped letting Lehman go under would show banks they had to be responsible for their own mess. But, this proved unworkable. It merely led to a defered intervention on an unprecedented scale.

Whilst this was a necessary evil to deal with the real threat of financial and economic meltdown, it still leaves the thorny problem of making banks responsible given the implicit state intervention.

The taxpayer should be rightly annoyed at the amount of their money going to bailout banks, making sure it doesn't happen again is easier said than done. (see: problem of bank regulation)

Related

• Liquidity of banks
• Why we save banks
• Economic crisis explained
  

Pessimistic Growth Forecasts

After one of the deepest recessions since the Great Depression, there have been the first signs of positive economic growth, but despite this there are still many potential problems for the economy going into 2010.

Many economists predict a sluggish recovery with the chance of the economy stagnating or growing very slowly over next 12 - 18 months. This will be bad news for unemployment and the government desperate for improved tax receipts.

Factors Which Make Recovery Difficult

Rates can Only Rise. The number of mortgage defaults has been less than predicted. This is because many are surviving due to the exceptionally low interest rates. As the economy recovers and interest rates rise, many homeowners may struggle to survive. It is the same for people with other types of personal debt. Any rise in interest rates will hamper economic growth.

Taxes will rise. The government is reluctant to maintain a large budget deficit of over 10% of GDP in the medium term. Several tax cuts are scheduled to expire - leading to effective tax rises. (e.g. VAT cut to 15% will expire in Jan 09) As the economy recovers, market appetite for government debt will reduce meaning governments will need to tackle the structural deficit through higher taxes and / or lower government spending.

Banks still reluctant to lend. Despite quantitative easing and low interest rates, banks are still being cautious about lending.

Unemployment will persist for many months to come. Even if we experience small positive economic growth, this is unlikely to dent the rise in unemployment as spare capacity continues to exist. High unemployment will depress spending by both the unemployed and those who fear unemployment.

New Era of Frugality. After the unprecedented damage of the recent recession, consumers are likely to be more cautious about spending. This will be good in that we may finally try to deal with our personal debt and saving rates will rise. But, it means consumer spending will be depressed and growth lower. The level of personal debt is greater than GDP, so the debt burden will remain a significant factor depressing spending in the future. See: New era of frugality

Global Growth. The level of global growth may play a key role in picking countries out of recession. So far China and India have performed well, providing growth in demand for exports, but, the Chinese economy shows signs of fragility with an overheated property market and an undervalued.

Despite all this there are some positive signs

• Confidence appears to be returning.
• House price falls have appeared to stabilise halting the long period of falls.
• If we do continue with a stagnating, the Monetary authorities will be able to maintain zero interest rates (there is even talk of negative interest rates), and pursue further quantitative easing.
• Exports have showed signs of picking up following weak pound and recovery in Germany and France

But, overall, it is hard to see anything but a slow recovery.

Obama Making Great Depression Mistakes?

According to a report by economists Charles Rowley of George Mason University and Nathanael Smith of the Locke Institute There are "troubling similarities" between the US President's actions since taking office and those which in the 1930s sent the US and much of the world spiralling into the Great Depression. The new pamphlet, published by the Institute of Economic Affairs has been endorsed by Nobel Laureate James Buchanan, who said:

"We have learned some things from comparable experiences of the 1930s' Great Depression, perhaps enough to reduce the severity of the current contraction. But we have made no progress toward putting limits on political leaders, who act out their natural proclivities without any basic understanding of what makes capitalism work."

In particular, the authors, claim that the White House's plans to pour hundreds of billions of dollars of cash into the economy will undermine it in the long run.

To some extent I agree with their analysis. I agree it was a terrible mistake to have

• Fiscal expansion and higher government borrowing during the Bush years of 2001-06. These years of economic growth should have been a time to reduce government debt, not cut tax and increase the deficit.
• Reckless Monetary expansion in 2001-07 encouraging a boom in house prices and stock market which led to subsequent bust and credit crunch which caused the most devastating recession since the 1930s.

However, I disagree with their analysis that deficit spending in a recession is harmful.

If excessive government indebtedness is a major source of the problem, why increase the government debt? Why encourage households to go yet further into debt?

If we learnt anything from the Great Depression, it was the necessity for the government to offset the rapid rise in private sector spending. (see: Principles of borrowing to see how the rise in government borrowing has offset the rise in private sector saving)

The great mistakes of the Great Depression were:

• Allowing so many banks to collapse
• Pursuing deflationary fiscal policy. Trying to balance the budget through higher taxes and lower spending. This mistake occurred at the beginning of the Great Depression and also in 1937, where a tightening of fiscal policy pushed the US back into a second recession.

Keynesian fiscal policy does not mean we have to increase the size of the public sector in the long run. It does not mean we want to maintain a permanently low saving rates. Keynesian fiscal policy is attempting to stabilise the economy during a period of economic contraction and rapidly rising unemployment.

It is not that we are trying to encourage more private sector debt. We are trying to prevent a too rapid fall in consumer spending which would cause an even larger rise in unemployment. The deficit spending is cyclical. Boosting growth is one of the best ways to increase tax revenues. When the economy is strong enough, the fiscal expansion can be reversed.

True, the burden of debt, is a problem. With an ageing population and increased health costs it will provide a challenge over medium and longer term. But, high government debt is not necessarily as crippling as some would like to exaggerate.

After the war, US debt was over 125% of GDP. Even by 1950, National debt was over 80%, this proved no barrier to the US having two decades of very strong economic growth. (Paul Krugman explains more at - A couple of notes on 40s and 50s)

Fears That Didn't Materialise

It is nearly a year since the dramatic collapse of Lehman Brothers. At one time last year, the financial and economic system looked to be entering into meltdown with quite a few cataclysmic predictions

The worst fears haven't materialised. That doesn't mean things are good. We are still looking at the worst recession since the 1930s and one of the highest levels of unemployment in the post war period. Combined with record levels of public debt it makes for a difficult few years. But, I guess its something that it could have been a lot worse.

Banking Collapse.

After Lehman's unexpected demise, and banks not lending to each other. It looked like a frozen credit market could cause many banks to fall like Domino's. It raised the spectre of the 1930s when 100s of US banks went bankrupt contributing to the Great Depression.
The global banking bailouts may have been badly managed - with the tax payer getting a raw deal; it was also rather sickening to see incompetent rich Wall Street Bankers bailed out by the taxpayer, but, despite all this the worst was avoided and a sense of fragile confidence did return. Banks are still nursing large losses which continue to worsen during the recession. But, it could have been a lot worse.

Hyper Inflation.

Despite the worst downturn since the 1930s, there were fears in certain quarters of a return to hyperinflation due to the Central Banks decision to create money through quantitative easing. This fear was largely misplaced in a period of spare capacity and a falling velocity of circulation. The link between inflation and money supply is more complicated. Most countries are avoiding a deflationary spiral, but, inflationary pressures are still very muted.

Debt Default.

The UK and US public sector debt have been increasing at a record pace. The UK is running its largest peacetime public sector deficit. This increase in national debt raised fears of much higher interest rates, and an inability of the government to sell the debt. However, so far the the markets have maintained a strong appetite for buying government securities.

A repeat of Great Depression.

Since the last quarter of 2008, GDP fell at a very sharp rate. Annualised quarter falls reached nearly 10% in countries such as UK, Japan and Germany. When GDP falls at this rate there is danger of a the worsening economy getting out of control. However, unprecedented monetary and fiscal policy stimulus helped to revert the situation and now most economies are forecast to return to economic growth soon. The falls in output were combined with some of the gloomiest confidence.

The fact we the worst fears didn't materialise is hardly great news, since they were pretty dire to begin with.

There is also a danger that the first shoots of growth may cause a premature relief that the problem is over. The economy still faces high and rising levels of unemployment. The growth is still based on rocky foundations which will need careful nurturing.

Is The Recession Over?

A recent report by the OECD suggested global growth was recovering quicker than expected.
After the shock of Q1, the OECD is now forecasting 0 or positive growth for many countries.

Annualised Quarter on Quarter Growth

Q1 2009

• US - 6%
• Japan - 11%
• Eurozone - 9.2%
• Germany - 13%
• UK - 9.3%

Q4 2009 (forecast)

• US 2.4%
• Japan - 0.9%
• Eurozone -2.0%
• Germany -1.8%
  
• UK - 0.0%

These are still forecasts and given the uncertainty, they could be different.
The only three countries to technically come out of recession are Japan, Germany and France. Both Germany and France posted positive growth in Q2 of 2009.

However, even when a country returns to positive economic growth, it doesn't mean the recession will feel like it is over.

• Firstly, there is always a chance that a period of positive growth may be followed by more quarters of negative growth. For example, Japan posted annualised quarter growth of 3.3% in Q2 2009, but is forecast to slip back into recession with negative growth in the fourth quarter of 2009.

• Also, even when growth becomes positive, unemployment is likely to keep rising. Or at the very least, it will take a long time for unemployment to fall. For example, in the Eurozone the rise in unemployment has been muted by strong protection for labour; this means it is more difficult to fire workers, but, also means firms can be more reluctant to hire when the economy recovers. (see: Unemployment)
  

• Falling house prices and the ending of fiscal tax cuts will keep spending low and lead to sluggish growth. If growth is very low (e.g. less than 1%, there can still be a rise in spare capacity)

It could take a long time for economies to return to a period of stable growth. Neverthless, the statistics on global growth are promising because they will help to boost exports and confidence.

Note: Annualised Quarter on Quarter growth means we look at growth for an economic quarter and multiply by 4. e.g. if GDP fell by 2.3% in Q1 of 2009. This means the annualised quarter on quarter growth is -9.2%

Why Are Sensible Policies Often Politically Unthinkable?

Often economic policies which make good sense and can leave everyone better off are dismissed as being politically unthinkable. How does this come about?

Let us take an example of a Congestion Charge.

Driving into city centres causes negative externalities such as pollution, congestion and higher fuel consumption. People can spend hours of their life stuck in traffic jams, but despite the wastage of congestion they do not want a tax neutral congestion charge which would reduce pollution, reduce the length of traffic jams.

If a government raises revenue from a congestion charge, it can use this money to reduce other taxes. This is why we say this is 'tax neutral' - the overall tax burden hasn't changed. We are just paying different taxes. The only difference is that the taxes are now forcing people to make more efficient choices which lead to less pollution and congestion. (since the London Congestion charge was introduced traffic volumes fell, average traffic speeds increased and pollution levels decreased)

This policy can lead to a net gain for society. Yet, they are often seen as politically unacceptable. Why?

Unfair on low income Groups. When the Mayor of New York proposed a congestion charge on driving into Manhattan, it was attacked as a way to stop poor people driving into Manhattan.

• However, a congestion charge doesn't have to alter income distribution. The money raised from a congestion charge can be used to reduce other regressive taxes - taxes on low income groups. We shouldn't promote inefficient policies just because they help the poor. We should choose the most efficient taxes and make sure we have the optimal income distribution.
• You don't have to sit in a traffic jam just to help people on low incomes.

(Whilst we are on income distribution. One of the most bizarre pieces of conventional wisdom is the dislike of inheritance tax. Tax on inherited wealth does the most to reduce wealth inequality, it does nothing to distort economic behaviour. Furthermore, inherited wealth is unearnt (unlike income) and yet the general public will vote for a reduction of inheritance tax - even though it is the super rich who will benefit by far the most.)

Another New Tax. People dislike new taxes. It seems people don't look at the overall tax they pay, but the number of taxes. (as an anecdote, my father probably gets more mad paying 50p for parking his car in a city centre than he does paying £5,000 a year income tax. Another £1 on income tax he wouldn't notice, but 50p parking fee he really does.) But, if the overall tax burden stays the same, it shouldn't matter how we pay for it.

Just an excuse for raising revenue. A very popular criticism on new taxes is that it will be just another excuse for raising revenue. But, the aim of these taxes is not to increase the overall tax burden but, to shift the way we pay tax to be more efficient. Unfortunately, it can be difficult to explain the idea of tax neutral policies. Either politicians don't express the ideas clearly or voters don't believe / understand. But, even if it was partly to raise revenue - it is the taxpayer will benefit through higher public spending, lower government debt or lower taxes in long run.

Other Reasons Good Sense policies are politically unpopular.

Losers are More Vocal.

Policies often benefit society; the social benefits are greater than the social costs, but, one small and powerful group in society loses out. It is this small group which becomes politically motivated to stop the policy.

For example, cutting tariffs leads to an increase in overall economic welfare. The majority of the population will benefit from lower prices, increasing their disposable income. However, the lower prices are relatively small. It won't make a big difference to their standard of living. It is unlikely to swing their vote because import prices are a little lower. However, lower tariffs could lead to unemployment for a few workers in inefficient industries who can't compete under free trade. Their loss is potentially big, so they will lobby their MP to protect their jobs. The number who lose out is very small, but they become highly organised and exert political influence. Therefore we get stuck with higher tariffs even though it doesn't make sense.

• A good example was the Common Agricultural Policy (CAP). For decades this lead to higher food prices, (hurting those on low incomes most), food surpluses, and damage to the environment just so wealthy farmers could benefit from the large EU subsidies and tariff protection.

• If there is an increase in net economic welfare it should be possible to ensure a pareto improvement (make sure everyone becomes better off). If there is a net gain to society, part of this gain can be used to help the inefficient factories close down e.g. give workers retraining - encourage farmers to diversify. But, this option is politically difficult because a factory closure costs votes, on the other hand, a improvement in economic welfare widely distributed doesn't usually translate into votes.

Pressure Groups.

The US spends twice as much on health care as any other country. By any standards it is inefficient, bureaucratic and expensive. Despite the huge costs, many are left uninsured. One reason for the high cost / high bureaucracy is the involvement of private health insurers who make a steady stream of profit from the private insurance. An attempt to cut out the private companies who make large profits usually fails because the health insurance companies are willing and able to spend so much lobbying congress to keep the status quo. The uninsured patients or families bankrupt by health care, don't have the economic power and organisation to lobby congress.

Another problem of switching to a single payer system is that people don't like new taxes, the fact they and their firms would save more in reduced private insurance doesn't seem to matter. It is almost as if people would rather pay more through private payments than through taxes.

Related

• Three of the worst economic policies

Frugality and the Economy

The recent boom was remarkable in the record levels of consumer spending and consumer debt. Against a backdrop of rising house prices, consumers undertook record levels of personal debt leading to a fall in personal savings rates. In both the UK and US, personal saving rates fell close to 0%.

Since the housing market and economy abruptly turned, this consumer extravagance has evaporated as nervous householders have looked to pay off debts, increase their saving and save some money for a rainy day (prospect of unemployment).

Even as the US economy recovers - (e.g. manufacturing output bouncing back and confidence returning), there appears to be no return to the mantra of borrow and spend. The US consumer has gained a taste for frugality and it may last for a lot longer than just this period of economic recovery. In the long run, the change in attitudes of consumers and banks may prove to be at least one benefit of this current economic crisis.

This new preference to save can be seen through the rise in saving rates. After having mostly declined for the past 15 years, the US saving rate reached a low of under 1% in the first half of 2008. Since then the rate has increased back to 4.2% in July. This is still low by historical standards, but, it does come during a period of unemployment and falling incomes (some people are having to run down savings because of a worsening situation). It is a similar story in the UK, where last month consumers reduced their total debt for the first time in several years.

What is Impact of This New Frugality and Higher Saving Rates?

In the short term, the desire to save makes monetary policy less effective. It is the propensity to save which partly explained why 0% interest rates didn't encourage spending. This is why the Fed and Bank of England resorted to unorthodox measures to boost aggregate demand. If saving rates continue to rise sharply during the recovery, it will mean they will need to be careful to avoid prematurely cutting off demand. (see: Paradox of thrift for more detail on the problem of rapidly rising saving rates)

In the longer term a rise in savings has more benefits.

• Will help reduce the persistent US current account deficit and the long term imbalance with other countries (primarily China and Japan)
• Higher savings may encourage a more balanced economy with lower spending but relatively higher levels of investment.
• Cutting the addiction to debt is definitely good in the long term. With high levels of indebtedness it makes the banking sector vulnerable to default and consumers are vulnerable to rising interest rates. It appears that many have been burnt by the boom and bust asset bubbles and now consumers are more cautious about getting into debt and believing 'the good times always role'
  

So, as is often the case, virtue (saving) is good; but maybe not too much too soon...