See part 1: Economics of the Naughties
Financial Markets need regulating.
Financial deregulation has been a disaster. Unchecked, the credit crisis shows that financial institutions can make basic mistakes in the pursuit of risky profit. Supporters of the free market have vainly tried to show the irresponsible loans of the naughties was actually due to government pressure. But, this is misleading, it was unregulated financial companies who made the vast majority of loans that had no chance of being repaid. There was a complete failure to adequately measure the level of risk involved in the buying of subprime loans. Somehow many of the NINJA mortgages (no income, no job) were rebundled, repacked and bundled as triple AAA credit rating. Western banks took these mortgages on, and it was the taxpayer who had to bailout their mistakes. Many banks pursued risky strategies of reducing liquidity ratios. There was a temptation to achieve short term profits by borrowing short to lend long. Northern Rock was once proud of it 125% mortgages. But, when the credit crisis hit, they were left unable to finance its positions. It was only when credit markets froze that they realised their business structure was flawed.
The Problem of Moral Hazard
A real problem we have is that banks acted on a premise of invulnerability. As we mentioned in this post, bankers often have an incentive to pursue risk. (problem of bank bonuses) Heads they win - tail the taxpayers lose. This is still a pressing issue - how to balance the need to ensure banking stability and prevent bank runs, without giving bankers a green light to pursue the most irresponsible strategy - knowing if they mess up someone else will clean it up.
One Tool Does Not fit
In the middle of the 2000s, it seemed that interest rates were the magic wand of the central bank to achieve any economic goal they wanted. Alas, this is not the case. Managing the economy is much more difficult that just changing interest rates. An interest rate cannot maintain strong growth, target inflation, and target asset bubbles all at the same time.
Keynesian economics
At the start of the recession, interest rates were slashed from 5% to 0%, without effect. We were in a liquidity trap where rate cuts may have no effect. In a liquidity trap, there is need for more - expansionary fiscal policy, quantitative easing. Faced with the failure of markets and the prospect of another Great Depression. The analysis of Keynes from the 1930s became very important.
Government Borrowing is necessary in a recession
One of the difficult things has been to explain, though government borrowing is bad, it would be even worse to try and reduce borrowing in the middle of a recession.
A boom is a time to reduce deficits.
Hindsight is a wonderful thing. But, at the height of the boom the decision to increase government borrowing was a painful mistake. America cut taxes and increased military spending. The UK increased spending on social security and health care. This meant both had large deficits before the recession started. This reduced room for maneouvre when the recession came.
Inflation Target can be Misleading
The central policy target of both UK and US was low inflation. With low inflation, neither governments could believe they were in the middle of an unsustainable boom. The low inflation rate, masked a boom in asset prices caused by unsustainable lending. A stable economy doesn't just need low inflation it needs stable asset prices, and sustainable bank lending.
Related
Tuesday, December 22, 2009
Monday, December 21, 2009
Economics of the Naughties
At the turn of the millennium, the landscape of economics was quite different. It was a period when major economies like the US and UK briefly had budget surpluses. It was a period of great optimism with people talking about the end of business cycle. For many analysts the world economy was living proof of the triumph of market forces, the efficient market hypothesis, and belief in the strength of unchecked capitalism. Yet, at the end of the decade, the global economy is still reeling from the biggest crisis since the Great Depression of the 1930s.
Here's a brief overview of some of the major economic events in the past decade.
The 2001 Recession
The terrorist attacks of 2001, contributed to a sharp downturn in the US economy leading to a mild recession. Faced with plummeting markets and falling output, the Federal Reserve acted quickly to cut interest rates and restore economic growth. The ease with which the Federal Reserve averted a prolonged downturn led to a round of self-congratulation amongst leading policy makers. As Paul Krugman noted 1997, it really did seem that:
It was also a period of financial deregulation, and financial innovation. Rising house prices encouraged a rash of new mortgage types. Never had it been so easy to get a mortgage. The combination of low interest rates and financial deregulation encouraged a new generation of homeowners to take out mortgages that previously would have been unthinkable. Based on a great sense of optimism of (seemingly) permanently rising house prices, banks seemed willing to lend a mortgage to just about anyone who could sign on a dotted line.
In the middle of a boom, the US cut income taxes and the UK increased government spending. Both of which caused a structural budget deficit. This worried few people at a time of prosperity, but was to become much more significant later.
Boom and Bust
With low inflation, low unemployment and strong growth. It appeared policy makers had achieved the holy grail of economic stability and constant growth. Talk of the end of the business cycle was common.
But, this stability masked an asset boom and a rise in unsustainable subprime lending, that nobody seemed to be aware about. At the start of 2006, few if any could have predicted how fragile the global financial system was. Healthy profits masked a much different story.
After keeping interest rates too low for too long, in 2005-06, the Federal Reserve finally began to increase interest rates. Nothing spectacular, interest rates were increased to 5%. But, even this modest rise in interest rates sparked one of the most spectacular wave of loan defaults the world economy has ever seen. It was only after a modest rise in interest rates that people started to realise how absurd many mortgage deals had been made.
After rising inexorably and against many optimistic forecasts (see: Books they wish they hadn't written ), US House prices started to fall and nervous banks started to realise alot of their sub-prime mortgages had all the foundations of a sand castle, based on the assumption the sea would always keep retreating.
In other times, this wave of mortgage defaults may have stayed in America. But, thanks to financial deregulation and a collective amnesia in analysing risk, the financial community had very nicely spread these toxic subprime loans all around the global financial system, rebundling them into seemingly anonymous Collateral Debt Obligations CDOs. If you don't understand what a CDO is, it seems many professional bankers didn't really know what they were buying either.
The result was that suddenly the liquidity evaporated from the global banking system. Everyone was hurrying to try and improve their balance sheets and recall toxic loans. But, it was too late, no-one wanted to lend to each other anymore. The cleverest and riskiest banking strategies now appeared for what they were - a recipe for self-bankruptcy. It all seemed like a bad joke, except, it was a very expensive joke with the taxpayer paying - see humorous look at sumprime crisis)
For more details see step by step Credit Crunch explained -
In the summer and autumn of 2008, it appeared no financial institution was safe. Just when you thought it could get no worse, another huge financial company announced they were on the verge of bankruptcy. Northern Rock, Bradford & Bingley, JP Mogan, Citigroup (to list but a small number who received government bailouts). Mostly, the taxpayer rode to the rescue and bailed out the banks with mind blowing sums. But, for whatever reason, when it came to Lehman Brothers, the American authorities decided to say "sorry, but, no". It was perhaps a brave and courageous decision. But, it was a decision they were to quickly regret. Financial markets and consumers panicked - the great assumption that no bank could possibly fail was suddenly exposed as a myth. Now, no bank now was safe. The only thing to do well was gold and mattresses as people sought to hoard their wealth in gold or cash under the bed.
The crisis precipitated the biggest fall in GDP since the great depression. In fact the start of the 2008 recession was just as severe as the Great Depression. With collapsing house prices, banks on the verge of bankruptcy, and confidence hammered, there was a real possibility of another depression.
To be fair after making so many mistakes in allowing the bubble and credit crunch, the response of governments to the crisis was reasonable. At least some of the mistakes of the Great Depression had been learnt. Though it is a bitter pill to swallow, governments prevented more bank collapses with bailouts. Interest rates were slashed, expansionary fiscal policy was pursued and even the unorthodox monetary policy of quantitative easing was pursued to avoid the great threat of deflation.
The most pessimistic forecasts of another depression have been averted. But, that doesn't mean all is well. Far from it. Banks still nurse fragile balance sheets, economies are being propped up with unprecedented government intervention. Public debt has ballooned creating real threats of government default in various western economies. The recovery will be very difficult. Trying to balancing record debt against the need to maintain growth.
It was also a decade where the problems of global warming became increasingly apparent. But, a problem the global community seem unable or unwilling to tackle. If the scientific forecasts for global warming prove correct, the credit crisis could seem a minor problem compared to the devastation caused by rising sea levels and weather crisis.
Tomorrow:
Lessons from the Economics of the Naughties.
Here's a brief overview of some of the major economic events in the past decade.
The 2001 Recession
The terrorist attacks of 2001, contributed to a sharp downturn in the US economy leading to a mild recession. Faced with plummeting markets and falling output, the Federal Reserve acted quickly to cut interest rates and restore economic growth. The ease with which the Federal Reserve averted a prolonged downturn led to a round of self-congratulation amongst leading policy makers. As Paul Krugman noted 1997, it really did seem that:
“If you want a simple model for predicting the unemployment rate in the United States over the next few years, here it is: it will be what [Alan] Greenspan wants it to be, plus or minus a random error reflecting the fact that he is not quite God.” (When Greenspan was nearly God)
It was also a period of financial deregulation, and financial innovation. Rising house prices encouraged a rash of new mortgage types. Never had it been so easy to get a mortgage. The combination of low interest rates and financial deregulation encouraged a new generation of homeowners to take out mortgages that previously would have been unthinkable. Based on a great sense of optimism of (seemingly) permanently rising house prices, banks seemed willing to lend a mortgage to just about anyone who could sign on a dotted line.
In the middle of a boom, the US cut income taxes and the UK increased government spending. Both of which caused a structural budget deficit. This worried few people at a time of prosperity, but was to become much more significant later.
Boom and Bust
With low inflation, low unemployment and strong growth. It appeared policy makers had achieved the holy grail of economic stability and constant growth. Talk of the end of the business cycle was common.
But, this stability masked an asset boom and a rise in unsustainable subprime lending, that nobody seemed to be aware about. At the start of 2006, few if any could have predicted how fragile the global financial system was. Healthy profits masked a much different story.
After keeping interest rates too low for too long, in 2005-06, the Federal Reserve finally began to increase interest rates. Nothing spectacular, interest rates were increased to 5%. But, even this modest rise in interest rates sparked one of the most spectacular wave of loan defaults the world economy has ever seen. It was only after a modest rise in interest rates that people started to realise how absurd many mortgage deals had been made.
After rising inexorably and against many optimistic forecasts (see: Books they wish they hadn't written ), US House prices started to fall and nervous banks started to realise alot of their sub-prime mortgages had all the foundations of a sand castle, based on the assumption the sea would always keep retreating.
In other times, this wave of mortgage defaults may have stayed in America. But, thanks to financial deregulation and a collective amnesia in analysing risk, the financial community had very nicely spread these toxic subprime loans all around the global financial system, rebundling them into seemingly anonymous Collateral Debt Obligations CDOs. If you don't understand what a CDO is, it seems many professional bankers didn't really know what they were buying either.
The result was that suddenly the liquidity evaporated from the global banking system. Everyone was hurrying to try and improve their balance sheets and recall toxic loans. But, it was too late, no-one wanted to lend to each other anymore. The cleverest and riskiest banking strategies now appeared for what they were - a recipe for self-bankruptcy. It all seemed like a bad joke, except, it was a very expensive joke with the taxpayer paying - see humorous look at sumprime crisis)
For more details see step by step Credit Crunch explained -
In the summer and autumn of 2008, it appeared no financial institution was safe. Just when you thought it could get no worse, another huge financial company announced they were on the verge of bankruptcy. Northern Rock, Bradford & Bingley, JP Mogan, Citigroup (to list but a small number who received government bailouts). Mostly, the taxpayer rode to the rescue and bailed out the banks with mind blowing sums. But, for whatever reason, when it came to Lehman Brothers, the American authorities decided to say "sorry, but, no". It was perhaps a brave and courageous decision. But, it was a decision they were to quickly regret. Financial markets and consumers panicked - the great assumption that no bank could possibly fail was suddenly exposed as a myth. Now, no bank now was safe. The only thing to do well was gold and mattresses as people sought to hoard their wealth in gold or cash under the bed.
The crisis precipitated the biggest fall in GDP since the great depression. In fact the start of the 2008 recession was just as severe as the Great Depression. With collapsing house prices, banks on the verge of bankruptcy, and confidence hammered, there was a real possibility of another depression.
To be fair after making so many mistakes in allowing the bubble and credit crunch, the response of governments to the crisis was reasonable. At least some of the mistakes of the Great Depression had been learnt. Though it is a bitter pill to swallow, governments prevented more bank collapses with bailouts. Interest rates were slashed, expansionary fiscal policy was pursued and even the unorthodox monetary policy of quantitative easing was pursued to avoid the great threat of deflation.
The most pessimistic forecasts of another depression have been averted. But, that doesn't mean all is well. Far from it. Banks still nurse fragile balance sheets, economies are being propped up with unprecedented government intervention. Public debt has ballooned creating real threats of government default in various western economies. The recovery will be very difficult. Trying to balancing record debt against the need to maintain growth.
It was also a decade where the problems of global warming became increasingly apparent. But, a problem the global community seem unable or unwilling to tackle. If the scientific forecasts for global warming prove correct, the credit crisis could seem a minor problem compared to the devastation caused by rising sea levels and weather crisis.
Tomorrow:
Lessons from the Economics of the Naughties.
Thursday, December 17, 2009
Why Current Accound Deficit Persists
The UK has had a persistent current account deficit in the past few years. However, given recent events we should expect an improvement in the current account deficit. Yet, rather surprisingly, the Current account deficit widened in the last quarter to be over 3.3% of GDP.
UK Current Account Deficit
Source: ONS retrieved Dec 14th 2009
The Current account deficit measures the balance of trade in
Why Current Account Deficit Should Have
Depreciation in Sterling. Since 2007, the value of Sterling has fallen over 20%. This should make British exports more competitive and imports more expensive. This should increase demand for our exports and reduce domestic consumption on imports. This should (assuming demand is relatively elastic) improve the current account deficit.
Deep Recession. Current account deficits tend to be cyclical. When consumer spending falls in a recession, it means we will buy less imported goods. UK consumer spending has fallen in 2009, due to higher unemployment and a rise in the savings ratio. In theory, this reduction in spending should reduce imports and improve the current account deficit.
Time Lags. The effect of a depreciation in the exchange rate often takes a long time to have an effect. Firms often have fixed contracts so it takes time for changed exchange rate to be reflected in prices. In the short term demand is often inelastic, but, over time becomes more elastic (Students of Economics may remember the J Curve Effect)
Slow Growth in other Countries. Although the UK consumer has been effected by the recession, so have our main competitors.
UK Current Account Deficit
Source: ONS retrieved Dec 14th 2009The Current account deficit measures the balance of trade in
- Goods
- Services,
- Investment incomes
- Current transfers
Why Current Account Deficit Should Have
Depreciation in Sterling. Since 2007, the value of Sterling has fallen over 20%. This should make British exports more competitive and imports more expensive. This should increase demand for our exports and reduce domestic consumption on imports. This should (assuming demand is relatively elastic) improve the current account deficit.Deep Recession. Current account deficits tend to be cyclical. When consumer spending falls in a recession, it means we will buy less imported goods. UK consumer spending has fallen in 2009, due to higher unemployment and a rise in the savings ratio. In theory, this reduction in spending should reduce imports and improve the current account deficit.
Why Deficit hasn't Fallen
Terms of Trade hasn't changed. As we looked at here: Terms of Trade Effect The depreciation has not led to a change in the terms of trade. To summarise- Import prices have increased (as expected)
- But, export prices have also increased.
Time Lags. The effect of a depreciation in the exchange rate often takes a long time to have an effect. Firms often have fixed contracts so it takes time for changed exchange rate to be reflected in prices. In the short term demand is often inelastic, but, over time becomes more elastic (Students of Economics may remember the J Curve Effect)
Slow Growth in other Countries. Although the UK consumer has been effected by the recession, so have our main competitors.
Outlook for Long Run
In the long run, I would expect an improvement in the current account.- Higher profit margins in exports should encourage more firms to increase supply
- More expensive imports should over time switch demand to domestic consumption.
- The UK recession seems to be longer lasting than our European competitors.
Wednesday, December 16, 2009
List of Countries Risk of Debt Default
CMA, have produced a lastest report showing the credit worthiness of Countries sovereign debt. They use various measures to produce analysis of a countries likely probability of defaulting on its government debt.
Cumulative Probability of Default (CPD) quantifies the probability of a country being unable to honour its debt obligations over a given time period.
Factors which influence a Countries probability of debt default include:
Source: CMA Report December 14th 2009 via Alea
The Riskiest Countries include
The UK is ranked 26th in the world. Its 5 year CDS rating detoriorated during the past few quarters from an index of 47 to 77. The UK has an implied credit rating of AA
Related
Cumulative Probability of Default (CPD) quantifies the probability of a country being unable to honour its debt obligations over a given time period.
Factors which influence a Countries probability of debt default include:
- Market Credit Default Swaps CDS - This reflects how much premium investors want to hold risky bonds. It becomes a good guide to market sentiment on the riskiness of debt. (See: Credit Default Swaps explained)
- Level of Sovereign Debt as a % of GDP
- Political influences - is there the ability to cut spending e.t.c
Source: CMA Report December 14th 2009 via Alea
The Riskiest Countries include
- Venezuala - 57% risk
- Ukraine - 54%
- Argentina - 49%
- Latvia - 30%
- Iceland - 24%
The UK is ranked 26th in the world. Its 5 year CDS rating detoriorated during the past few quarters from an index of 47 to 77. The UK has an implied credit rating of AA
Related
Monday, December 14, 2009
Debt Planning and Debt Panic
When should we panic about the level of national debt?
Greece recently had its credit rating downgraded from A- to BBB. This year Greece had an annual budget deficit equal to 12% of GDP. Unfortunately, this is a rather similar level to the UK budget deficit. So does that mean we could face a similar fate to those reckless Greeks? - facing a credit downgrade, higher interest rates and a loss of investor confidence?
Firstly, there are a few differences.
For example, cut public spending in Greece and we could have a return to the riots of a few years ago.
A key issue for the UK is do we have a credible plan to reduce debt? At the moment, all the talk, is wait until after the general election. That is fine, but, after the general election, we really will need to give concrete plans.
When it's Good to Borrow
High levels of Debt certainly creates economic problems. But, reducing deficits too quickly can cause additional problems. The problem with panicking over debt is that we may create even worse problems. (see: Causes of Great Depression)
Greece recently had its credit rating downgraded from A- to BBB. This year Greece had an annual budget deficit equal to 12% of GDP. Unfortunately, this is a rather similar level to the UK budget deficit. So does that mean we could face a similar fate to those reckless Greeks? - facing a credit downgrade, higher interest rates and a loss of investor confidence?
Firstly, there are a few differences.
- The total level of Greek National debt is much higher than the UK. The current level of Greek government debt is 113% of GDP. The forecast for 2010 is 125% of GDP, and the EU fear it could rise to 135% of GDP by 2011. (Beware of Greeks bearing government bonds, could well become an oft-repeated joke)
By comparison the UK public sector debt doesn't look too bad (59.2% of GDP - though we are doing our best to try and catch up...) - Greek debt reflects a long term structural deficit. The level of borrowing cannot be explained away by financial support for banks or a mild recession. The UK's debt is more geared towards cyclical fluctuations and the figures look less damaging when financial bailouts are excluded. (total national debt is 49% of GDP, excluding financial bailouts). However, there is no guarantee that a return to growth will restore faith in UK public finances. The recession has certainly hit tax revenues, but, there is uncertainty when, if ever, they will recover. The UK finances deteriorated very rapidly in the recession, but, the deficit is not just cyclical but also structural.
Do you Have a Plan To Reduce Debt?
Ireland has one of the largest budget deficits in the World (14% of GDP this year). But, it has been going about reducing the deficit with a vigour which is the envy of other European countries. As the Economist says (link)WHEN the Irish finance minister, Brian Lenihan, in effect cut the pay of public-sector workers earlier this year by introducing a special 7% pension levy, he confessed that Ireland’s European Union partners were amazed at the muted public reaction. There would, he said, have been riots in France.The ability to cut public spending and raise taxes gives investors confidence in buying debt. The problem Greece may have is a credibility problem. They have a long history of getting into debt, and markets are more suspicious of their ability to repay. It's not just how much debt you have, but, whether markets have faith you are likely to restore public finances without resorting to printing money.
For example, cut public spending in Greece and we could have a return to the riots of a few years ago.
A key issue for the UK is do we have a credible plan to reduce debt? At the moment, all the talk, is wait until after the general election. That is fine, but, after the general election, we really will need to give concrete plans.
When it's Good to Borrow
High levels of Debt certainly creates economic problems. But, reducing deficits too quickly can cause additional problems. The problem with panicking over debt is that we may create even worse problems. (see: Causes of Great Depression)
- In a recession, borrowing is necessary. Trying to reduce a deficit in a recession can cause a further fall in economic growth and a further fall in tax revenue. Promoting growth is one of best ways of promoting future tax receipts.
- To finance investment in economy. If you invest in new roads, communications, education e.t.c. It may help the economy be more productive and grow faster. This can help improve tax revenues in the long term.
However, if you are borrowing to finance pensions and welfare benefits there will be no improvement in productivity
Wednesday, December 9, 2009
Aftermath of Iceland Economic Crisis
What happens when your financial sector and economy collapses?Iceland will provide an interesting case study for future economists
To recap:
The initial anger of Icelanders at their bankers, their government, the British government, foreign bankers e.t.c has somewhat melted away and people have started to view their lifestyle in a new light. I have a few friends who run a cafe in Reykavik, they tell me the initial fears of the crisis proved to be less dangerous than they first feared. Business has held up reasonably well, what they really notice is how expensive foreign travel has become. They also suggest, the fashion for expensive luxuries and SUVs are fading are being replaces by a more frugal, simplistic, "back to our Viking routes" kind of lifestyle. It's no longer so fashionable to pose in Dolce & Gabanna imports, it is more fashionable to be making homemade hair dye, from an old Viking recipe. (See also: Frugality and the economy, we looked at how frugality was becoming popular in US)
Yet, the economy remains vulnerable. The collapse of the financial sector means they are still reliant on fishing for over 40% of export revenues. This makes the economy vulnerable to depletion of stocks or fluctuations in the price of fish. There is a need to diversify and develop the economy, but, not the diversification of buying toxic subprime mortgage debts the Icelandic banks tried to their cost.... (By, the way, in 2009, the Icelandic banks were awarded the reverse IGnoble Nobel Prize for economics by Harvard University. That is pretty impressive since one ig prize was awarded for the bra which could easily be converted into two gas masks.... Ignoble Prizes list)
Many now see the EU has offering salvation for the economy. But, joining the EURO does not solve your underyling problem as Greece, Spain and Ireland are learning to their cost.
Related
To recap:
- Iceland's banking sector expanded rapidly as they lent money to financial institutions around the world.
- The foreign exposure of Icelandic banks were enormous, their loans and other assets totalled more than 10 times the country's GDP
- In 2007/08, the subprime mortgage crisis led to a spate of loan defaults in the US, but, this spread around the world. Icelandic banks had exposure to these toxic loans and soon there losses mounted. Given extent of banking loans, Icelandic banks suddenly looked very vulnerable.
- Despite government attempts the banks went bankrupt and they were forced to borrow $10bn from the IMF.
- Rapid depreciation in the Currency.
- This reduces living standards and increases price of imports
- McDonalds recently left Iceland because a Big Mac would be too expensive after importing raw materials
- Unemployment has increased from 1% to 10%
- GDP has fallen 7%
- Inflation has increased to 11%
The initial anger of Icelanders at their bankers, their government, the British government, foreign bankers e.t.c has somewhat melted away and people have started to view their lifestyle in a new light. I have a few friends who run a cafe in Reykavik, they tell me the initial fears of the crisis proved to be less dangerous than they first feared. Business has held up reasonably well, what they really notice is how expensive foreign travel has become. They also suggest, the fashion for expensive luxuries and SUVs are fading are being replaces by a more frugal, simplistic, "back to our Viking routes" kind of lifestyle. It's no longer so fashionable to pose in Dolce & Gabanna imports, it is more fashionable to be making homemade hair dye, from an old Viking recipe. (See also: Frugality and the economy, we looked at how frugality was becoming popular in US)
Yet, the economy remains vulnerable. The collapse of the financial sector means they are still reliant on fishing for over 40% of export revenues. This makes the economy vulnerable to depletion of stocks or fluctuations in the price of fish. There is a need to diversify and develop the economy, but, not the diversification of buying toxic subprime mortgage debts the Icelandic banks tried to their cost.... (By, the way, in 2009, the Icelandic banks were awarded the reverse IGnoble Nobel Prize for economics by Harvard University. That is pretty impressive since one ig prize was awarded for the bra which could easily be converted into two gas masks.... Ignoble Prizes list)
Many now see the EU has offering salvation for the economy. But, joining the EURO does not solve your underyling problem as Greece, Spain and Ireland are learning to their cost.
Related
Tuesday, December 8, 2009
Policies to Reduce Global Warming
Global warming is one of the hottest topics at the moment. The problems of Global warming are potentially devastating. But, as expected there are many ready to tell us global warming is a hoax and policies to tackle the problem will lead to unemployment, lower output and could damage the economic recovery.
Whatever, your opinion about the reality of global warming, I feel that there are many policies to reduce global warming which will not damage the economy but can actually benefit it.
Tax on Carbon.
Taxing carbon emissions provides firms with incentives to create more efficient industries. It creates incentives to switch to carbon free production. It may cause temporary unemployment amongst industries who are carbon intensive. (these are the groups lobbying hard to protect against any carbon taxes and co-incidently often find evidence global warming is a hoax e.t.c). But, the overall effect on the economy and unemployment should be neutral. Jobs will be created in technology and industries which promote low-carbon emissions. Tax rises in carbon can lead to lower taxes on other environmentally friendly industries. Alternatively, the tax revenue can be used to subsidise the development of solar power technology e.t.c
Carbon taxes should not be seen as a revenue raising / deflationary fiscal policy. It is merely an efficient way to encourage a more environmentally friendly economy. It is merely switching the tax burden, placing tax on those activities which cause most harm to society and the environment.
When London was covered in smog in the 1950s, legislation stopped open fires. Undoubtedly some jobs were lost in the open fire / coal industry, but, jobs were created in the alternative such as gas and electric fires. We managed to reduce smog without a permanent rise in unemployment and permanent fall in GDP. I think most people would argue the government intervention to reduce smog improved living standards and improved the environment.
It is the same story with acid rain. In the early 1980s, we became aware of the damage done by acid rain. The usual suspects fought against tax and regulation to limit the creation of pollution, but, in 1990 the United States went ahead with a cap-and-trade system for sulfur dioxide. It did not lead to a loss of output, but, helped reduce sulphur pollution at limited cost. (an affordable cost)
The economy is adaptable. The idea we have to maintain existing industries at all cost to protect jobs and prevent a decline in output is absurd. Should we have kept slavery to protect jobs in the Liverpool docks? Should we have subsidised the coal industry to keep 0.5 million miners producing coal that nobody wanted anymore?
The truth is that we can reduce global warming without economic damage. The problem is that it might hurt some vested interests temporarily - so they fight tooth and nail to protect their industry - ignoring the wider implications.
Even if the threat of global warming turned out to be less real than the most pessimistic forecasts, we will have lost nothing by promoting more eco-friendly industries. Yet, if we do nothing and global warming does lead to rising temperatures and sea levels the effects could be catastrophic. As the Stern report [link] suggests - there could be a huge economic benefit to tackling global warming. Voters don't like the idea of 'new taxes'. They have to be sold how much they stand to gain from a more efficient tax system.
Hopefully, common sense will prevail and we will not gamble on the future of the world for the sake of a few leaked emails and the vested interests of a few multinationals. - well just my vain hope anyway.
Whatever, your opinion about the reality of global warming, I feel that there are many policies to reduce global warming which will not damage the economy but can actually benefit it.
Tax on Carbon.
Taxing carbon emissions provides firms with incentives to create more efficient industries. It creates incentives to switch to carbon free production. It may cause temporary unemployment amongst industries who are carbon intensive. (these are the groups lobbying hard to protect against any carbon taxes and co-incidently often find evidence global warming is a hoax e.t.c). But, the overall effect on the economy and unemployment should be neutral. Jobs will be created in technology and industries which promote low-carbon emissions. Tax rises in carbon can lead to lower taxes on other environmentally friendly industries. Alternatively, the tax revenue can be used to subsidise the development of solar power technology e.t.c
Carbon taxes should not be seen as a revenue raising / deflationary fiscal policy. It is merely an efficient way to encourage a more environmentally friendly economy. It is merely switching the tax burden, placing tax on those activities which cause most harm to society and the environment.
When London was covered in smog in the 1950s, legislation stopped open fires. Undoubtedly some jobs were lost in the open fire / coal industry, but, jobs were created in the alternative such as gas and electric fires. We managed to reduce smog without a permanent rise in unemployment and permanent fall in GDP. I think most people would argue the government intervention to reduce smog improved living standards and improved the environment.
It is the same story with acid rain. In the early 1980s, we became aware of the damage done by acid rain. The usual suspects fought against tax and regulation to limit the creation of pollution, but, in 1990 the United States went ahead with a cap-and-trade system for sulfur dioxide. It did not lead to a loss of output, but, helped reduce sulphur pollution at limited cost. (an affordable cost)
The economy is adaptable. The idea we have to maintain existing industries at all cost to protect jobs and prevent a decline in output is absurd. Should we have kept slavery to protect jobs in the Liverpool docks? Should we have subsidised the coal industry to keep 0.5 million miners producing coal that nobody wanted anymore?
The truth is that we can reduce global warming without economic damage. The problem is that it might hurt some vested interests temporarily - so they fight tooth and nail to protect their industry - ignoring the wider implications.
Even if the threat of global warming turned out to be less real than the most pessimistic forecasts, we will have lost nothing by promoting more eco-friendly industries. Yet, if we do nothing and global warming does lead to rising temperatures and sea levels the effects could be catastrophic. As the Stern report [link] suggests - there could be a huge economic benefit to tackling global warming. Voters don't like the idea of 'new taxes'. They have to be sold how much they stand to gain from a more efficient tax system.
Hopefully, common sense will prevail and we will not gamble on the future of the world for the sake of a few leaked emails and the vested interests of a few multinationals. - well just my vain hope anyway.
Monday, December 7, 2009
US Economy in 2010
After the deepest recession since the Great Depression, there is understandably considerable relief at the first signs of growth in the US. Recent job figures also suggest the economy has turned. However, some commentators worry that these first greenshoots could lead to a complacent feeling and that the US economy still faces many weakness in 2010.
This graphs shows the extent of the decline in economic output. The recession of 2009 easily dwarves the modest decline of 2001. The red line indicates the potential rate of economic growth. This shows how much spare capacity will exist in the US economy in 2010, this will make it difficult to tackle the unemployment problem.
The sharp rise in unemployment is perhaps the biggest problem facing the US economy. Like the UK, the rise in unemployment has been muted by a fall in working hours and increase in temporary employment. The bad news is that the forecast for unemployment in 2010 and 2011 is for a continued period of high unemployment.
Unemployment rates in 2010 and 2011 - source: P.Krugman
The Dollar in 2010
Many people might be a little surprise at how much the dollar rallied from the summer of 2008. But, this year, the dollar has regained its downward momentum, and it is hard to see a reversal in the dollar fortunes given state of economy.
There are some who apparently worry about inflation prospects in the US. But, I still feel the US has more to fear from inflation than deflation. Inflation is likely to remain low during 2010 because of the spare capacity and lack of wage pressures. As a consequence, interest rates are likely to remain low throughout 2010.
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Image Sources: St Louis Fed
Economic Growth and Spare Capacity
This graphs shows the extent of the decline in economic output. The recession of 2009 easily dwarves the modest decline of 2001. The red line indicates the potential rate of economic growth. This shows how much spare capacity will exist in the US economy in 2010, this will make it difficult to tackle the unemployment problem.
Unemployment in US
The sharp rise in unemployment is perhaps the biggest problem facing the US economy. Like the UK, the rise in unemployment has been muted by a fall in working hours and increase in temporary employment. The bad news is that the forecast for unemployment in 2010 and 2011 is for a continued period of high unemployment.Forecast for US Unemployment
Unemployment rates in 2010 and 2011 - source: P.KrugmanThe Problem with US Banking Sector
As we mentioned in a recent post - Worries over future home foreclosures - the US banking sector still faces more potential losses from home repossessions. This graph shows how much banks have been affected by the housing market crash and credit crunch. It will take a long time for banks to recover balance sheets and ability to lend like before the crash.Assets of US Banks
Budget Deficit
The US budget deficit continues its remorseless rise. Now over $12 trillion, it continues to rise as a % of GDP. It has also become an important political issue. With more voters apparantely concerned about the deficit than unemployment. The debt is a long term problem, but, efforts to reduce it in the short term could dampen the economic recovery and push the economy back into recession.
The Dollar in 2010
Many people might be a little surprise at how much the dollar rallied from the summer of 2008. But, this year, the dollar has regained its downward momentum, and it is hard to see a reversal in the dollar fortunes given state of economy.Inflation and Interest Rates
There are some who apparently worry about inflation prospects in the US. But, I still feel the US has more to fear from inflation than deflation. Inflation is likely to remain low during 2010 because of the spare capacity and lack of wage pressures. As a consequence, interest rates are likely to remain low throughout 2010.
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Image Sources: St Louis Fed
Thursday, December 3, 2009
Chinese Economic Bubble
Remember the days when banks were willing to make loans with little checks on ability to repay?
It was not so long ago, that we experienced a period of irrational exuberance. Based on a belief of the sustainability /inevitability of economic growth / property price rises, financial institutions were willing to take many risks lending to people with few credit checks. We ended up with a situation where 100% mortgages, mortgages many times incomes were lent out.
Also, the Central Banks failed to anticipate we were in an asset bubble and the economy was more fragile than statistics suggested. As a result, monetary policy was kept too loose. At a time, when monetary policy should have been tighter, the Federal Reserve kept interest rates very low, encouraging a boom in credit and confidence.
Now, surely, we wouldn't make the same mistake again. But, the problem is that China faces many similarities with the boom and bust years we recently had.
China has had an impressive record of economic growth. This record has encouraged a sense of exuberant confidence. Chinese policy makers find it hard to envisage anything other than a continuation of these record growth levels. Chinese policy has come to rely on a continuation of breakneck growth to prevent unemployment and a rise in political dissent.
Monetary policy is lax. To promote this break neck growth, Chinese monetary policy is relatively lax. This is particularly the case with exchange rate policy. To keep exports cheap, the exchange rate is been kept undervalued providing an artificial stimulus for exporters.
Government policy also includes subsidies have included direct credit allocation and preferential treatment for coastal enterprises. This risks creating growth which doesn't reflect market conditions.
A situation of high confidence, and low interest rates is encouraging a growth in bank lending, not necessarily to profitable or careful investments.
There is a boom in construction even though there is evidence of over capacity (aka Spain)
Even statistics are dodgy. Chinese GDP stats record output produced, rather than output sold. There is a difference as not all output is sold, leading to excess capacity. But, also, GDP statistics are treated with caution because local officials have an incentive to exaggerate and record higher figures.
Of course, the similarities are not complete. There are many differences between the Chinese and US / UK experiences. China has a high saving ratio, low government borrowing and a current account surplus. If they chose, they have room for damping inflationary pressure and trying to switch economy from export based to more consumer based. China has the potential to make rapid productivity growth because many of its former state owned industries were so inefficient.
But, if the Chinese economic miracle did come unstuck, it could have profound implications for China and rest of world.
Personally, I feel that China is in a position to become the dominant economic force. But, that doesn't mean it won't have a bumpy ride on the way to becoming the worlds largest economy.
Related
It was not so long ago, that we experienced a period of irrational exuberance. Based on a belief of the sustainability /inevitability of economic growth / property price rises, financial institutions were willing to take many risks lending to people with few credit checks. We ended up with a situation where 100% mortgages, mortgages many times incomes were lent out.
Also, the Central Banks failed to anticipate we were in an asset bubble and the economy was more fragile than statistics suggested. As a result, monetary policy was kept too loose. At a time, when monetary policy should have been tighter, the Federal Reserve kept interest rates very low, encouraging a boom in credit and confidence.
Now, surely, we wouldn't make the same mistake again. But, the problem is that China faces many similarities with the boom and bust years we recently had.
China has had an impressive record of economic growth. This record has encouraged a sense of exuberant confidence. Chinese policy makers find it hard to envisage anything other than a continuation of these record growth levels. Chinese policy has come to rely on a continuation of breakneck growth to prevent unemployment and a rise in political dissent.
Monetary policy is lax. To promote this break neck growth, Chinese monetary policy is relatively lax. This is particularly the case with exchange rate policy. To keep exports cheap, the exchange rate is been kept undervalued providing an artificial stimulus for exporters.
Government policy also includes subsidies have included direct credit allocation and preferential treatment for coastal enterprises. This risks creating growth which doesn't reflect market conditions.
A situation of high confidence, and low interest rates is encouraging a growth in bank lending, not necessarily to profitable or careful investments.
There is a boom in construction even though there is evidence of over capacity (aka Spain)
Even statistics are dodgy. Chinese GDP stats record output produced, rather than output sold. There is a difference as not all output is sold, leading to excess capacity. But, also, GDP statistics are treated with caution because local officials have an incentive to exaggerate and record higher figures.
Of course, the similarities are not complete. There are many differences between the Chinese and US / UK experiences. China has a high saving ratio, low government borrowing and a current account surplus. If they chose, they have room for damping inflationary pressure and trying to switch economy from export based to more consumer based. China has the potential to make rapid productivity growth because many of its former state owned industries were so inefficient.
But, if the Chinese economic miracle did come unstuck, it could have profound implications for China and rest of world.
Personally, I feel that China is in a position to become the dominant economic force. But, that doesn't mean it won't have a bumpy ride on the way to becoming the worlds largest economy.
Related
Wednesday, December 2, 2009
Why is UK Unemployment Not Higher?
A curious feature of this recession, is that despite its depth and length, unemployment has not risen further.
As this graph shows, the current recession has seen the largest fall in GDP - a fall of 6% in the past 6 quarters.
Also, in the other recessions, the economy recovered quite quickly. This speed of recovery is not predicted in 2010.
This shows that despite a rapid fall in GDP in 2009, the rise in unemployment has been relatively modest. Given previous recessions, we could have expected a higher unemployment rate.
Why is unemployment not higher?
I think there are a few possible explanations:
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UK recession of 2009 compared to 1991 and 1981
As this graph shows, the current recession has seen the largest fall in GDP - a fall of 6% in the past 6 quarters.
Also, in the other recessions, the economy recovered quite quickly. This speed of recovery is not predicted in 2010.
Unemployment in Recessions of 1981, 1991 and 2009
This shows that despite a rapid fall in GDP in 2009, the rise in unemployment has been relatively modest. Given previous recessions, we could have expected a higher unemployment rate.
Why is unemployment not higher?
I think there are a few possible explanations:
- Official statistics underestimate true level of unemployment. Government changes have made it more difficult to claim benefits. Therefore, official unemployment is underestimating the true level of full time employment. Another way of considering unemployment is the employment rate. For example, currently 72.5% of the working age population is in active employment. ONS It would be interesting to find the statistic for employment rates in 1991 and 1981.
- This time, the recession has hit the financial services sector more than previous recessions Financial services could be relatively less labour intensive than manufacturing .
- Firms have sought to avoid unemployment by cutting back on hours or strict pay deals.
- An increase in young people going to higher education to avoid a very difficult labour market. Or an increase in older workers taking early retirement
- Labour Market protection. Unemployment in the US has risen more quickly than in Europe. Many suggest this is because labour markets in US are more flexible. In other words it is easier to hire and fire workers. This makes US unemployment more volatile. European unemployment rates rise slower in a recession, but, also fall more slowly during recovery. However, I am uncertain the extent of labour market protection for UK workers.
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Tuesday, December 1, 2009
Inflation Rate Projections
Projected CPI Inflation: Source: BofE
Note: The fan shows potential inflation rate. The area in the middle (darkest) is the most likely inflation rate. The longer the time period, the more difficult to predict inflation, which is why the fan projection gets wide.
The latest Bank of England inflation predictions suggest the future medium term outlook for inflation will be uncertain. In the short term, inflation could increase sharply. But, in the medium term, spare capacity should keep inflation low.
Inflation could increase in short term because of:
- VAT rise from 15% to 17.5%
- Rising oil prices
- Depreciation in Pound which makes imported goods cheaper.
Should We Be Worrying About Inflation?
Some are worrying about a long term threat of inflation. For example, they suggest- The scale of quantitative easing may be difficult to reverse.
- The unprecedented monetary and fiscal expansion may start to have an increasing effect in the future.
- The rise in the price of gold suggests markets are nervous about future inflation (or at least just nervous).
- The temporary factors which will push up inflation are misleading. It is like the inflation spike of 5% in early 2008, just as we were heading into recession. This made Central Banks keep interest rates too high. But, the inflation proved to just be a temporary blip rather than an underlying reflection of excess demand.
- It is hard to see how inflation can be a serious threat, when there is so much spare capacity in the economy. It could take until 2012 to regain the previous level of GDP. Even then, there will still be spare capacity.
- The costs of inflation are sometimes exaggerated. Of course, inflation can cause real instability in an economy (see: costs of inflation). It is good to avoid unsustainable inflationary growth. But, if inflation does go above an arbitrary target of 2%, it should not be a reason to necessarily panic. It is not just low inflation which is the holy grail of economic policy. At least, not when you have an unemployment rate approaching 10%.
projected growth (past forecasts not been very accurate)Projected GDP Growth (Bank of England)
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