Boom and Bust Economic Cycles

Definition of Boom and Bust: A period of rapid economic expansion which is unsustainable leading to subsequent period of economic contraction and recession.

The Great Moderation

Was the great moderation a period of boom and bust?

 

Inflation stayed low between 1992 and 2009. It wasn't a classic boom. Economic growth was positive, but it wasn't significantly higher than the long run trend rate. Inflation stayed low.

However, although growth and inflation were stable in the 1990s and 2000s, there were still components of a boom and bust.

Housing Boom and Bust

In the late 1990s and early 2000s, there was a housing boom and bust. UK House prices rose much faster than inflation until Summer 2007, when the credit crunch completely changed the nature of the mortgage market. As mortgages were withdrawn, house prices started to fall. But, because mortgage affordability was stretched, people were not able to save the new size of deposits. Because prices had risen so much they had a long way to fall. The fall in house prices has played a crucial role in knocking consumer spending and consumer confidence. It has directly led to job losses in construction and estate agents.

The boom and bust in housing is quite clear and has played a key role in the current bust.

Unbalanced Economy A boom and bust suggests an unbalanced economy. In the growth years of 2000-08, there was a strong growth in consumer spending and consumer borrowing. This is reflected in the:

• falling savings ratio
• Rise in mortgage equity withdrawal.
• Higher consumer borrowing
• current account deficit. - financed by hot money flows and higher interest rates.

In other words, the main cause of UK economic growth was consumer spending. The economic growth was not balanced throughout different sectors. Because saving rates are so low, it means that the UK is particularly sensitive to the rising living costs and tighter credit conditions.

Lawson boom and bust of the 1980s.

In the late 1980s economic growth increased to 5% a year in 1988 and 1989. This was far above the long run trend rate and this excessive growth caused inflation to rise to double figures. In response to the inflationary spiral, the government joined the ERM and increased interest rates. This reduced inflation, but, at the expense of switching the boom into a painful bust. House prices collapsed (not because of a financial crisis, but because interest rates were so high). Unemployment rose and the government dithered in stimulating the economy because it was pursuing an outdated target for sterling against the D-Mark. See Lawson boom
Implications of Boom and Bust.

The UK did have its longest period of economic expansion on record - 1992-2008. In part this was due to avoiding a boom and bust cycles which have been frequent in the post-war period. However, you could say there was a boom and bust cycle in financial markets. Lending rose rapidly, but this later proved unsustainable.

This recent crisis, raises the importance of looking beyond headline inflation and economic growth statistics. Low inflation is not the only factor we need to look at. It is a mistake to ignore house prices bank lending and other indicators of economic / financial volatility.
There is also a danger of relying on consumer spending to fuel growth.
There is also a danger of attracting hot money flows to finance a current account deficit. And there is a danger of allowing lending criteria to become so relaxed that any tightening creates economic problems. 

• Causes of the Business Cycle

European Recession

After the first European recession in 2009, the EU is heading back into another recession only three years later. But, this recession is much more worrying. There is less room for maneouvre, attempts to solve the debt crisis have failed, and have left countries with both low growth, but continuing debt problems.

The cause of the second recession is depressingly simple.

• Austerity policies really do cause a fall in aggregate demand, higher unemployment and lower economic growth
• If you cut government spending, you need something else to boost demand in the economy. This could be devaluation, loose monetary policy, higher exports or stronger private sector demand and investment. 
• However, Europe has only deflationary policies. There is no devaluation for southern economies, no loosening of monetary policy and with very low confidence, the private sector has not compensated for even minor spending cuts. 
• The German economy is doing relatively well (though GDP still fell 0.2% in the last quarter). But, the German economy is helped by very strong export demand. Germany has a current account surplus of 6% of GDP. The problem is that some feel everyone should follow German's model of exports and high current account surplus. But, not everyone can have a current account surplus! 
• The flipside of strong German exports is a current account deficit in Greece and Portugal of 10% of GDP. To help economic growth in Greece and Portugal, there needs to be a revaluation of trade within the EU - but that is very slow to occur with a single currency.
• In a liquidity trap and period of very low private confidence, the private sector haven't taken the place of spending cuts. It is why Italy has gone into recession with GDP falling 0.7% in last three months of 2011, following 0.4% contraction in three months before.

Austerity and Lower Tax Receipts

Since Greece increased taxes, and cut spending, VAT receipts have fallen 18% in 201. Simply because 60,000 firms went out of business. This is an example of how austerity policies can be self-defeating in a recession. (Tragedy of Greece)

Yet, Daniel Mitchell, of the libertarian-minded Cato Institute, argues that Europe has not been austere enough and that much more is needed. "European countries talk about austerity but they don't mean cuts," he says. (Guardian Link). At least the IMF are aware that there can be too much of a necessary thing. (IMF blog)

Youth unemployment of 50% - just cut government spending a bit more. This is the logical policy of free market economics.

Yet, despite all the austerity of Greece, Italy and Ireland, they have failed to solve the 'debt crisis'

Depressed with the European economy, I had a look at the Indian economy in 2012 - at quite a different stage of the economic cycle. What India needs is to reduce its budget deficit and liberalise its complex bureaucracy. If India can lears anything from Europe - don't wait for an economic downturn to try and solve persistent budget deficits.

Keynesian economics may support fiscal expansion during a recession, but in India's case, a very different approach is needed.

Related

• Causes of recession
• Euro debt crisis Explained

Outlook for Euro

A look at some of the challenges facing the Eurozone and why the Euro is likely to remain weak over coming months.

The Euro has been weak ever since the debt crisis began at the start of 2010.

Challenges for the Euro

1. Current Account Imbalances


The single currency has created economic imbalances in the Eurozone.

• Germany has a large current account surplus (almost 6%) - suggesting German exports are undervalued.
• By contrast, Greece has a current account deficit of 11%.
• Portugal has a current account deficit of over 7%.
• In Q3, the UK had a deterioration in current account deficit to 4% of GDP (despite devaluation since 2009.
• To restore competitiveness in Greece and Portugal without devaluation would require a prolonged period of deflation. This deflation would lead to lower growth and higher unemployment.

2. Government Debt

Greece and Ireland have a high budget deficit. But, it also shows that the problems of the Euro are more than debt. Portugal and Spain have high bond yields - despite a relatively low budget deficit. Portugal and Spain have a budget deficit 50% less than similar deficits in the UK and US. Yet, US and UK don't have rising bond yields.

• List of government debt by country

3. Unemployment

Unemployment rates in the Eurozone present a real threat to social stability - especially since unemployment is more concentrated amongst young workers.

4. Low Economic Growth

Growth forecasts for the Eurozone have been downgraded. For southern Europe, there will be a double dip recession, making it harder to reduce debt to GDP ratios and increasing unemployment. Unfortunately, it is hard to see a strategy for growth. There will be no loosening of monetary policy. The exchange rate will remain overvalued for the uncompetitive south. And at the same time, they have to reduce spending to tackle budget deficits. Combined with a European wide slowdown, it will be a slow and limited recovery.

Related

• Problems of the Euro

Predictions for Pound Sterling to Euro

Predictions for Pound Sterling to Euro in 2012

Readers Question: I read a lot about the Dollar/Pound relationship but I want to know what the forecast is going to be for Euro/Pound. What is the factor that determines the value of the Pound down against the Euro?

The Main factors determining the value of the Pound Sterling to Euro

• Relative interest rates - If UK interest rates are higher than Eurozone, this will attract hot money flows from Europe to UK. This will increase demand for sterling, and sterling will appreciate
• Prospects for economic growth. If the UK economy grows quicker than the Eurozone, we would expect UK interest rates to increase faster than in Euro, causing an appreciation in Sterling.
• Prospect for inflation. If UK inflation is higher than in Eurozone, it will make UK goods relatively less competitive than Euro goods. This will cause less demand for UK goods and a devaluation in the value of Sterling.
• Government Debt. If markets fear government default, this makes them less willing to hold currency which the debt is denominated. If markets feared the UK government may default, foreign investors would sell UK bonds, pushing down the value of the exchange rate.
  

Graph showing Value of Euro to Pound

Reasons Why the Pound Devalued against the Euro in 2008/09

1. UK Economy in steepest recession. The UK economy experienced a rapid drop in GDP (Steeper than even Great Depression of 1930s). The UK was particularly hard hit by credit crunch because of the UK's exposure to financial services. Because of the sharp slowdown in UK GDP interest rates were cut to 0.5% in March 2000
   Lower interest rates are very important for weakening a currency. Lower UK interest rates make it less attractive to buy Sterling and save the money in the UK. Therefore, there are less hot money flows and a weaker value of Pound.
2. Housing Market. The UK Housing Market plays a crucial role in determining consumer confidence, spending and economic growth. The fall in house prices has reduced consumer confidence and with house prices forecast to fall or stagnate in 2012, it is another factor which will keep interest rates low.
   
3. Credit Crisis. The UK is heavily exposed to the credit crisis because mortgage lending accounts for a high % of disposable income. Mortgage lending is more important in the UK than the Eurozone where mortgage payments account for a smaller % of disposable income. With less mortgages becoming available, demand for housing is falling. Also those with existing mortgages are seeing the cost of remortgaging increase. This is putting pressure on the Bank of England to reduce base rates to compensate for the increased bank rates. As they explained the recent interest rate cut:
   
   "The disruption in financial markets could lead to a slowdown in the economy that was sufficiently sharp to pull inflation below the target."
   
   
4. UK Current account deficit. Relative to the EU, the UK is running a current account deficit, which puts downward pressure on sterling because of the outflow of foreign currency. UK's current account deficit is still 4% of GDP (Q3 2011) despite devaluation.
   
5. Large Rise in Government Borrowing. With government bailouts, fiscal expansion and tax cuts, government borrowing will be close to 9% GDP in 2012/13. This causes lower confidence in the UK economy to pay off debt (though UK public sector debt is still lower than many of our European counterparts)
   

Predictions for Pound vs Euro in 2012

The Euro has become increasingly weak since the onset of the Euro debt crisis in early 2010. Markets fear default in countries like Greece, Italy and Portugal. This could lead to countries exiting the Euro. This uncertainty and fear over default has pushed the Euro lower. There is no quick fix to the Euro debt crisis. Efforts to reduce government borrowing have caused a slowdown in economic recovery and prospects of a double dip recession make markets more nervous over the Euro.
The UK's recovery is being held back by the Eurozone downturn. The UK is highly reliant on the EU for our exports. However, the UK still has greater flexibility than the Eurozone and recovery is likely to be stronger in the UK than in the south of Europe.

The strength of the Euro is also causing problems for EU exporters.

Conclusion

The Pound has fallen on the back of depressing economic statistics. The whole Global economy is likely to experience recession, but, the UK recession has been deeper than most. Against this backdrop the pound has been weaker.

Related:

• Outlook for Euro
• What causes a currency collapse?
  

Reference
Picture from : Guardian - Pound falls to record low

Should we Try and Save the Euro?

How much should we try to save the Euro?

Reasons to Save The Euro

1. Capital flows on Break up. The short term costs of a Euro break up, are potentially very high. The main problem would be massive capital flows from exiting countries (e.g. Greece, Italy)

If Italy left the Euro, Italian bond and Italian savings could see a 20-30% devaluation.
Therefore, investors with Italian bonds and savings will try to sell them and move their savings from Italy to other countries (e.g. Germany, UK, Switzerland and Japan)

This run on Italian banks could be devastating for Italy, but also have knock on effects on other European banks who would lose money through their exposure.

This European credit crunch would precipitate a fall in investment and economic output. To some extent the full scale of the financial fall out is difficult to predict because there are few if any precedents.

2. Other Benefits of the Euro. In comparison to what is happening in Europe now, these benefits seem rather insignificant. See benefits of Euro - but they are the reason for the Euro in the first place.

3. Intervention by ECB. Arguably if the ECB changed its policy stance and agreed to create money and buy bonds, it would be possible to save the Euro at much lower cost than the route of prolonged austerity.

Reasons Not To Save The Euro

The Euro is fundamentally flawed. Countries in Euro have become uncompetitive leading to lower growth and higher unemployment

Different Trends in Competitiveness

Harmonised competitive indicators in the EU (2011 Q1), source: ECB Stats based on unit labour costs indices for the total economy:

This shows how since 1998, Germany (DE) reduced costs by 18.5%. Greece by comparison saw a 9.7% increase in costs. (see more: Competitiveness in Europe) Yet they have the same currency! Therefore, there is inevitably an imbalance. Greek exports have become uncompetitive, but they can't devalue.

The result of competitiveness can be seen in statistics such as the current account.

Current Account deficits in the Euro

2. The Proposed Solution is not a solution

The only real solution offered by the EU, to the EUrozone crisis is to impose budget controls. Whether the Greek budget is managed by Germany directly or not. The message is clear - what we need is repeated spending cuts to meet budget targets. But, this is just a recipe for lower growth and rising GDP to debt ratios. The crisis is not just excessive government borrowing. If it was due to high budget deficits, why is the UK not seeing bond yields rise like Portugal?

It is the lack of competitiveness that the Euro can't deal with. The Euro is creating a climate of economic austerity, which inevitably leads to higher unemployment. Why seek to save a currency which isn't working.

3. The Euro has fundamental problems:

• Lack of independent monetary policy
• lack of exchange rate flexibility
• No lender of last resort causing greater turbulence in bond markets.
• The ECB is geared towards low inflation in Germany and has little interest in promoting growth in Southern Europe
  

See: Problems of Euro

Conclusion

It is a really difficult choice. Leaving the Euro could potentially be very damaging. It could lead to a very severe credit crunch and recession. But, patching up the Euro in its present form could lead to persistent high unemployment and low growth - especially in those countries with uncompetitive exchange rates.

Could the Euro work? Well it could in theory, but it's hard to see how the 16 countries can quickly come to economic harmonisation.

• Why does Euro try to save the Euro?