Understanding UK Housing Market

The housing market is said to be one of the most popular topics of conversation at dinner parties. In the UK, this is for good reason. Houses are by far the biggest form of household wealth and have a big impact on consumers and the economy.

This graph shows two main features of the UK housing market.

• House prices are volatile with frequent booms and busts.
• Despite volatility, and even adjusted for inflation - UK house prices have been on a strong upward trend since the 1930s.

Main factors affecting house prices

• Supply. UK house prices have stayed relatively high (despite recession and credit crunch) because of a shortage of supply. Ireland and Spain have seen much bigger house price falls because they have large excess supply.
• Interest rates. The UK housing market is sensitive to changes in interest rates. Higher interest rates in the early 1990s made mortgages unaffordable and caused a big drop in house prices.
• Economy / unemployment. A recession and rising unemployment usually causes lower demand for buying houses and a fall in price. (falling house prices also tend to deepen the recession)
• Mortgage availability. In the boom years of 2000-07, banks were keen to lend and they relaxed their lending criteria, enabling more people to get a mortgage. But, the credit crunch meant banks had to tighten their lending criteria making mortgages difficult to get (even though interest rates were low)
• see more at: factors affecting housing market

Why are UK house prices so volatile?

UK house prices have been highly volatile in the past few decades. On the one hand this is unexpected. People don't buy and sell houses like a commodity. But, in practise, house prices are volatile for a number of reasons.

• Inelastic supply. It takes time to build houses - with rising demand, supply often can't keep up. This pushes prices up.
• Change in credit conditions. Mortgage availability can vary depending on the state of the banks and financial markets.
• Changing interest rates. Interest rates are used to control inflation, but a rise in interest rates has a big effect on demand and affordability.
• Changes in confidence. In the boom years, we see landlords buying to let and demand rises. When prices fall, people don't want to buy for fear of negative equity.

Why are UK house prices so expensive?

 (graph showing nominal house prices)

UK house prices are very expensive. Despite the credit crunch, UK houses are still less affordable in 2013 than at the end of the Lawson boom in the 1980s.

If we look at the affordability of mortgage payments, buying a house looks more affordable because interest rates are much lower in the 2010s, than in the 1990s. But, with house prices nearly 7 times average earnings in London, buying a house is out of the question for many first time buyers.  Generally, mortgage companies only lend 3-4 incomes. It is too difficult to raise a deposit. Why are house prices so expensive?

1. Demand rising faster than supply. The UK fails to build enough houses to meet growing demand. This is related to strict planning legislation and the frequent local opposition to building new houses. Home building was also hard hit by the credit crunch. See more at Supply of houses

 2. Squeezing onto the property market. As well as a shortage of supply, people try very hard to buy a house despite its expense. For example, some young people may benefit from generous loan or help from their parents to help get them on the property ladder. London has seen strong demand from overseas buyers; parts of the countryside has seen the purchase of second homes, pushing house prices higher.

Housing market crashes

If the UK had a boom in housing builds, we may have had a similar experience to Ireland. In the boom years, Irish house prices rose 300%, but between 2006 and 2012, house prices collapsed, falling more than 50%. The main difference is that Ireland were building record numbers of houses, leaving a glut in the property market. Irish boom and bust. See also boom and bust in US housing market

How does the Housing market affect the rest of the economy?

Housing is the biggest form of personal wealth in the UK. Changes in house prices have a significant effect on UK household wealth and confidence. If house prices are rising, homeowners can gain extra cash through re-mortgaging their house and spending the extra equity (this was a feature of the 1980s and 2000s boom). Therefore, rising house prices tend to increase consumer spending. However, if people see falling house prices, they lose capacity to re-mortgage and also consumer confidence tends to fall, leading to lower spending. Falling house prices in 2009 and 1990 were key factors in contributing to the recessions of those periods.

see more at:  Housing market and economy

Government intervention in the housing market

Ideally, the government would overcome market failure in the housing market. This would involve:

1. Increasing supply to overcome fundamental shortage.
2. Protecting green belt land
3. Ensuring minimum standards of house building and ensuring tenants get a fair deal
4. Seeking to avoid house price volatility.

However, 1 and 2 conflict. The government often say they want to build new houses, but this is often politically unpopular with local protests against the building of new houses. Governments often focus on helping first time buyers, through government backed mortgages - but this has been criticised for not solving the fundamental problem house prices are too expensive, and just encourages greater debt levels.

Related posts on the housing market

• Market failure in housing
• Cause of falling house prices
• Latest stats and graphs on the housing market
• Problems of UK housing market
• Impact of falling house prices

Advantages and Disadvantages of Trades Unions

Trade unions are organisations representing the interests of workers. They were formed to counter-balance the monopsony power of employers and seek higher wages, better working conditions and a fairer share of the company's profits.

Critics of trade unions argue they can be disruptive to firms, discouraging investment and improved working practices. Furthermore, powerful unions can lead to macroeconomic problems such as wage inflation and lost productivity due to strike action.

In the post-war period, trade unions gained substantial power and had a large influence over wages, unemployment and the economy. However, with the decline of manufacturing industries, unions have gone into decline and some economists argue this has contributed towards increased wage inequality.

This is a look at the main pros and cons of trade unions in the modern economy.

Advantages of Trades Unions

1. Increase wages for its members

Industries with trade unions tend to have higher wages than non-unionised industries. Trade unions can pursue collective bargaining giving workers a greater influence in negotiating a fairer pay settlement.

The efficiency wage theory states that higher wages can also lead to increased productivity. If workers feel they are getting a higher wage, they can feel more loyalty towards the firm and seek to work for its success.

2. Counterbalance Monopsony Power

In many industries, firms have a degree of monopsony power. This means firms have market power in employing workers. It enables firms to pay wages below a competitive equilibrium (W2) and also employ fewer workers at Q2. There are many cases of powerful firms making a very high level of profit, but paying relatively low wages.

If firms have monopsony power, then a trade union can increase wages without causing unemployment. Even if a trade union successfully bargained for a wage of W3 - employment stays the same as Q2. If a trade union bargains for W3, it does not create unemployment, but employment stays at Q2.

In the face of monopsony employers, trades unions can increase wages and increase employment. Traditionally, monopsonies occur when there is only firm in a town or type of employment. However, in modern economies, many employers have a degree of monopsony power - related to difficulties of moving between jobs.

3. Represent workers

Trades Unions can also protect workers from exploitation, and help to uphold health and safety legislation. Trades unions can give representation to workers facing legal action or unfair dismissal.

4. Productivity deals

Trades unions can help to negotiate and implement new working practices which help to increase productivity. For example, in wage negotiations, firms may agree to increase pay, on the condition of implementing new practices, which lead to higher productivity. If the trade union is on board, then they can help create good working relationships between the owners and workers.

5. Poor wage growth in non-unionised workforce

Modern labour markets are increasingly flexible with weaker trade unions. These new developments in labour markets have led to a rise in job insecurity, low-wage growth and the rise of zero-hour contracts. Non-unionised labour helps firms be more profitable, but wages as a share of GDP has declined since 2007. Unions could help redress the monopoly power of modern multinationals.

In 2011 there were 6,135,126 members in TUC-affiliated unions, down from a peak of 12,172,508 in 1980. Trade union density was 14.1% in the private sector and 56.5% in the public sector.

6. Reduce inequality


From the late 1890s to 1980s, the UK saw a growth in trade union membership. This was also a period of falling inequality and a reduction in relative poverty. Since trade union membership peaked in the early 1980s, this trend of reduced inequality has been reversed and inequality has increased.

source: Paris School of Economics

Potential disadvantage of Trades Unions

1. Create Unemployment

If labour markets are competitive, and trade unions are successful in pushing for higher wages, it can cause disequilibrium unemployment (real wage unemployment of Q3-Q2).  Union members can benefit from higher wages, but outside the union, there will be higher unemployment.

It is also argued that if unions are very powerful and disruptive, it can discourage firms from investing and creating employment in the jobs. If firms fear frequent strikes and a non-cooperative union, they may prefer to invest in another country with better labour relations. For example, in the 1970s, the UK experienced widespread industrial unrest and this is cited as a factor behind the UK's relative decline.

2. Ignore non-members

Trades unions only consider the needs of its members, they often ignore the plight of those excluded from the labour markets, e.g. the unemployed.

3. Lost Productivity

If unions go on strike and work unproductively (work to rule) it can lead to lost sales and output. Therefore their company may go out of business and be unable to employ workers at all. In many industries, trade unions have created a situation of a confrontational approach.

Decline in trade union density has led to a decline in days lost to strikes.

4. Wage-inflation


If unions become too powerful they can bargain for higher wages above the rate of inflation. If this occurs it may contribute to wage-inflation. Powerful trades unions were a significant cause of the UK's inflation rate of 25% in 1975.

Evaluation

The benefits of trades unions depend on their circumstances. If they face a monopsony employer they can help counterbalance the employers market power. In this case, they can increase wages without causing unemployment. If unions become too powerful and they force wages to be too high, then they may cause unemployment and inflation

It also depends very much on the nature of the relationship between trade unions and employers. If relations are good and constructive, the union can be a partner with the firm in maintaining a successful business, which helps protect jobs and higher wages. However, if the relationship between trade unions and the management become confrontational, it can escalate into destructive partnerships which cause a decline in profitability and puts the long-term security of jobs at risk

Related

• The UK economy under Mrs Thatcher 1979-1984
• Trade Unions

Importance of Economic Growth

Economic growth means a rise in real GDP; effectively this means a rise in national income, national output and total expenditure. Economic growth should enable a rise in living standards and greater consumption of goods and services. As a result, economic growth is often seen as the 'holy grail' of macroeconomics

However, this simplistic emphasis on economic growth is often criticised because living standards depend on many more factors than just increasing real GDP. Some economists have suggested that a more useful measure is to look at a wider range of factors, such as the Human Development Index (HDI) which measures GDP but also statistics such as literacy and healthcare standards. Some also argue we should not be using GDP but, a happiness index. (does economic growth increase happiness?)

Why economic growth is important

Economic growth can help various macroeconomic objectives

• Reduction in poverty. Increased national output means households can enjoy more goods and services. For countries with significant levels of poverty, economic growth can enable vastly improved living standards. For example, in the nineteenth century, absolute poverty was widespread in Europe, a century of economic growth has lifted nearly everyone out of this state of poverty. Economic growth is particularly important in developing economies.
• Reduced Unemployment. A stagnant economy leads to higher rates of unemployment and the consequent social misery. Economic growth leads to higher demand and firms are likely to increase employment.
• Improved public services. Higher economic growth leads to higher tax revenues (even with tax rates staying the same). With higher growth, incomes and profit, the government will receive more income tax, corporation tax and expenditure taxes. The government can then spend more on public services. 
• Reduced debt to GDP ratios. Economic growth helps reduce debt to GDP ratios. In the 1950s, the UK had a national debt of over 200% of GDP. Despite very few years of budget surplus, economic growth enabled a reduction in the level of debt to GDP.
  
  
• Political aspect. Elected politicians have a vested interest in higher economic growth. Higher growth enables vote pleasing policies such as tax cuts and/or more public spending.

Virtuous cycle of economic growth

 

• Countries with positive rates of economic growth will create a virtuous cycle
• Economic growth will encourage inward investment as firms seek to benefit from rising demand
• Higher growth leads to improved tax revenues which can be spent on long-term public sector works, such as improved transport and communication. This helps long-term growth.
• Confidence to invest. Higher growth encourages firms to take risks - innovate and invest in future products and productive capacity.

Limitations of economic growth

• Inequality and distribution. Economic growth doesn't necessarily reduce relative poverty, it depends on the distribution of incomes. Economic growth could bypass the poorest in society. For example in the 1980s, the Gini coefficient rose sharply - the richest 1% gained dis proportionality more.
• Negative externalities. Economic growth can cause negative externalities such as pollution, higher crime rates and congestion which actually reduce living standards. For example, China has experienced very rapid economic growth but is now experience very serious levels of air pollution in major cities.
• Economic growth may conflict with the environment. e.g. increased carbon production is leading to global warming. Economic growth may bring benefits in the short-term, but costs in the long-term.
• It depends on what is produced. The Soviet Union has fantastic rates of economic growth, but, often through producing a lot of steel and pig iron that was not actually very useful.
• Economic growth can be unsustainable. If growth is too rapid, it will cause inflation, current account deficit and can lead to boom and bust.
• Does happiness actually increase? Theories of hedonistic relativism suggest (beyond a certain level) increasing output has no effect on changing life quality or happiness.

Related

• Causes of Economic Growth
• Benefits of economic growth
• The Importance of Economics

Liquidity Trap Explained

A liquidity trap occurs when low/zero interest rates fail to stimulate consumer spending and monetary policy becomes ineffective. In this situation, an increase in the money supply will fail to increase spending and investment because interest rates can't fall any further.

A liquidity trap means consumers' preference for liquid assets (cash) is greater than the rate at which the quantity of money is growing. So any attempt by policymakers to get individuals to hold non-liquid assets in the form of consumption by increasing the money supply won't work.

In the post-war period, the macro-economy was managed by changing interest rates and there was no incidence of a liquidity trap (outside Japan). However, in 2008, the global credit crunch caused widespread financial disruption, a fall in the money supply and serious economic recession. Interest rates in Europe, US and UK all fell to 0.5% - but, the interest rate cuts were very slow to cause economic activity to return to normal. 

Liquidity Trap 2009-15

In the UK, base interest rates were cut from 5% in 2008 to 0.5% in March 2009. Yet, for a considerable time, the economy remained in recession and growth remained weak. This period is a good example of a liquidity trap.

Interest rate cuts to 0.5% did little to create a strong economic recovery.

Money Supply Growth in Liquidity Trap

A feature of a liquidity trap is that increasing the money supply has little effect on boosting demand.
One reason is that increasing the money supply has no effect on reducing interest rates.

When interest rates are 0.5% and there is a further increase in the money supply, the demand for holding money in cash rather than investing in bonds is perfectly elastic.

This means that efforts to increase the money supply in a liquidity trap fail to stimulate economic activity because people save more cash reserves. It is said to be like 'pushing on a piece of string'

In the liquidity trap, there was an increase in the monetary base (due to Quantitative easing) but the broad money supply (M4) showed little increase.

MO (monetary base) increased by over 7% in 2009 - but, it couldn't stop the decline in M4.

See also: Explaining Paradoxes of UK economy

Why do Liquidity Traps Occur?

• Inelastic demand for investment. In a liquidity trap, firms are not tempted by lower interest rates. The marginal efficiency of capital indicates the rate of return from investment. Usually, lower interest rates make it more profitable to borrow and invest. However, in a recession, firms don't want to invest because they expect low demand. Therefore, even though it may be cheap to borrow - they don't want to risk making investment.

• Expectations of deflation. If there is deflation or people expect deflation (fall in prices) then real interest rates can be quite high even if nominal interest rates are zero. - If prices are falling 2% a year, then keeping cash under your mattress means your money will increase in value. The difficulty is in having negative nominal interest rates (banks would be paying you to borrow money). (There have been attempts to create a negative interest rates (e.g. destroy money in circulation but in practice, it is rarely implemented.)
• Preference for saving. Liquidity traps occur during periods of recessions and a gloomy economic outlook. Consumers, firms and banks are pessimistic about the future, so they look to increase their precautionary savings and it is difficult to get them to spend. This rise in the savings ratio means spending falls. Also, in recessions banks are much more reluctant to lend. Also, cutting the base rate to 0% may not translate into lower commercial bank lending rates as banks just don't want to lend.

at the start of the credit crunch, there was a sharp rise in the UK saving ratio.

• Credit Crunch. Banks lost significant sums of money in buying sub-prime debt which defaulted. Therefore, they are seeking to improve their balance sheets. They are reluctant to lend so even if firms and consumers want to take advantage of low-interest rates, banks won't lend them the money.
• Unwillingness to hold bonds. If interest rates are zero, investors will expect interest rates to rise sometime. If interest rates rise, the price of bonds falls (see: inverse relationship between bond yields and bond prices) Therefore, investors would rather keep cash savings than hold bonds.
• Banks don't pass base rate cuts onto consumers

In a liquidity trap, commercial banks may not pass base rate onto consumers.

How to overcome a liquidity trap

• Quantitative Easing - policy to create money and reduce yields on government and corporate bonds
• Helicopter money - more direct than quantitative easing as rather than buying assets from banks, the money is given directly to the people.
• Expansionary Fiscal Policy - Keynes argued in a liquidity trap, it is necessary for a government to pursue direct investment in the economy. For example, building public work schemes has the effect of creating demand and getting unused resources back into the circular flow.
• Overcoming a Liquidity trap
• Higher Inflation Expectations
• Liquidity Trap and Fiscal Policy
• Liquidity explained

Interest Rates explained

Interest rates reflect the cost of borrowing. They also indicate the return on savings/bonds.

Commerical banks charge a higher interest rate on loans and pay a lower rate on savings. This difference between the cost of borrowing and rate of return on savings is part of the reason banks are profitable. Lending customers deposits at a higher rate than they pay customers interest on their savings.

Types of interest rates

Interest rates are controlled by the Central Bank (sometimes governments set interest rates directly). The Central Bank change a base rate. This base rate is the rate they charge to commercial banks. If the base rate rises, commercial banks will tend to put up their standard variable rates.

Effect of an Increase in Interest Rates

If interest rates go up, we will see:

1. Cost of borrowing is more expensive. If borrowing is more expensive consumers will take out fewer loans. Firms will borrow less. Therefore consumer spending and investment will fall (or increase at slower rates)
2. Mortgage and loan repayments increase. This reduces consumer disposable income and consumer spending further.
3. Return on savings increase. More attractive to save and this will reduce consumer spending
4. Higher interest rates cause an appreciation in the exchange rate due to hot money flows. (It is more attractive to save in the UK, if UK interest rates are higher than other countries)
5. An appreciation in the exchange rate makes more expensive, leading to less export demand
6. Fall in asset prices. Higher interest rates can make it less attractive to buy a house with a mortgage leading to lower house prices.

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Macro effects

• If consumer spending and investment falls, this will lead to lower AD. Therefore this causes a fall in Real GDP or at least a fall in the rate of economic growth.
• Lower growth will tend to increase unemployment. With less output, firms demand less workers.
• Lower growth will also help to reduce inflation.

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Evaluation of Interest rate increases

1. Depends on the situation of the economy


If the economy is at full capacity a rise in interest rates may reduce inflation, but not growth. However, if there is already spare capacity then rising interest rates could cause a recession.

2. Depends on other components of AD

For example, if exports are rising, or if consumers confidence is high; rising interest rates may not reduce AD. For example, in the late 1980s, there were modest rises in interest rates, but the other aspects of the economy were growing so quickly, it failed to halt the above trend rate of growth (until 1991/92 when interest rates reached a record 15%)

3. Income effect of higher interest rates

Higher return on saving may give some consumers a high income. This will be consumers like pensioners. However, in the UK, the savings ratio is quite high, therefore the income effect of a rise in interest rates is likely to be quite low. The substitution effect will be higher.

4. It depends whether commercial banks pass interest rate cut onto consumers. In the credit crunch, banks didn't reduce their Standard Variable Rate as much as the Bank of England cut its base rate.

In Credit Crunch of 2008, lower interest rates failed to boost economic growth.

How does Bank of England decide whether to increase interest rates?

The Bank will look at a wide variety of statistics to consider the state of the economy. The most important factors are

• Inflation target of 2%. But Bank has to consider other objectives such as
• economic growth and inflation.
• It also has to consider the type of inflation. Is it temporary cost-push inflation or underlying inflationary pressures.
• Is the economy reaching full capacity?

Example of interest rate dilemma Nov 2017

Should interest rates go up?

Real interest rates

Real interest rate = nominal interest rate - inflation rate.

If interest rates are 5%, and inflation is 3%, the real interest rate is 2% - savers will see a positive return on savings.

However, if interest rates stay at 5% and inflation rises to 6%, then real interest rates become negative. Real interest rates will be -1.0%

See also:

• Interest rates and the economy
• Essay on Effects of Rising interest rates
• Interest Rate Swaps explained

The Economy of the 1970s

See previous decade - 1960s.

The 1970s was not just an era of dayglow trousers, lava lamps and the emergence of punk rock. It was a traumatic economic decade of stagflation, a three day week and the return of unemployment. Yet, despite some headline-grabbing crisis - it was also a decade of rising living standards, the growth of credit and rising property prices.

Graph showing combination of high inflation and volatile output.

Barber Boom 1970-73

 The early years of the 1970s were a period of rapid economic growth.

1. The Bank of England deregulated the mortgage market - meaning High Street Banks could now lend mortgages (not just local building societies). This helped fuel a rise in house prices and consumer wealth.
2. Barber Boom of 1972. In the 1972 budget, the chancellor Anthony Barber made a dash for growth - with large tax cuts against a backdrop of high economic growth.
3. Growth of Credit. It was in the 1970s, we saw the first mass use of credit cards (Access). This helped create a consumer bubble.

Inflation Crisis

By 1973, inflation in the UK was accelerating to over 20%. This was due to:

• Rising wages, partly due to strength of unions.
• The inflationary budget of 1972.
• Growth in credit and consumer spending.
• Oil price shock of 1973, leading to 70% increase in oil prices.

Trying to deal with inflation

Belatedly, the government tried to deal with unemployment, through higher interest rates. Also, the Heath government tried capping wages. This was fuel for industrial unrest, leading to frequent and widespread strikes. In 1973, the miners went on strike and were also joined by sympathetic trades unionists - led by, amongst others, the young and infectiously strident Arthur Scargill. Growing up in Thatcher's Britain, it is hard to remember how powerful trades unions actually were at the time. During Heath's government 9 million working days were lost to strike action - plus more to practises such as 'working to rule'. Flying pickets successfully blocked coal and coke factories, which at the time produced the majority of the nation's power. Suddenly the life source of Britain's energy was being blocked. At the height of the strike, Britain was on a 3 day week, with the Prime Minister, Edward Heath making public appeals to conserve energy.

1974, also saw an unwelcome return of a real recession. This recession was caused by the end of the Barber boom and falling living standards from rising prices. In the post-war period, we had booms and busts, but, the bust were relatively mild, with only very minor declines in output. But, in 1974, output fell 3.4% causing a return of high unemployment not seen since the 1930s.


Oil Prices in the 1970s

• blue line - nominal oil prices
• Yellow line - Real oil prices, adjusted for inflation

Since oil had become an intrinsic part of the economy, we had taken it for granted that oil could be bought cheaply. The 1960s and early 1970s, saw a rapid rise in ownership of cars and motoring. Britain enthusiastically embraced the motor car - helped by rising incomes and cheap petrol.

But, the 1973 oil crisis, changed all that. Suddenly the price of petrol more than doubled and the UK faced an energy crisis to go along with a spike in inflation. The government seemed powerless as Britain was put on a three day week and TV was turned off at 10.30pm. Emergency speed limits were introduced to conserve petrol.

If in 1957, we had never had it so good, by 1973, it seemed we had never had it so bad. It was a return to the 1940s austerity; but with no obvious enemy, the public were less forgiving of this inconvenience.

UK current account


In the mid 1970s, the UK saw a deterioration in the current account. High UK inflation was making UK goods less competitive. Also domestic consumer spending remained relatively strong - sucking in more imports. Although the current account reached a peak of only 4% of GDP in late 1974, (low compared to current account in 2000s) there were greater concerns about financing the current account deficit in the 1970s due to less investment income

1976 IMF Bailout

In 1976, the UK needed to apply to the IMF for a bailout. This was due to high budget deficit and also concerns over the value of Sterling. Markets believed Sterling was overvalued and so kept selling. This caused the Pound to depreciate.

Britain asked the IMF for a £2.3bn bail out in 1976 saying unemployment and inflation were at exceptional levels.

In return the IMF insisted on deep spending cuts to tackle the budget deficit. The government implemented spending cuts. By 1977, the economy showed signs of recovery, and helped by oil revenues the balance of payments improved. The pound also strengthened after the loan. The UK did not need to draw-out the full loan. More detail at: IMF crisis

UK borrowing in the 1970s

From UK Budget deficit

UK budget deficit rose rapidly from 1971/72 to 1975/76
Due to rise in GDP, total public sector debt fell from approx 60% of GDP (1970) to 50% in 1980 (see: National debt

The Importance of Economics

Readers Question: What is the Importance of Economics?

Economics is concerned with helping individuals and society decide on the optimal allocation of our limited resources.

The fundamental problem of economics is said to be scarcity - the idea that wants (demand) is greater than the resources we have. The economy faces choices on

• What to produce? - Is it worth spending more on health care?
• How to produce? - Should we leave it to market forces or implement government regulations.
• For whom to produce? - How should we distribute resources, should we place higher income tax on the wealthiest in society?

More specific questions include

How to manage the macro economy?

Mass unemployment in the 1930s

Both inflation and mass unemployment can be devastating for society. Economists argue that both can be avoided through careful economic policies. For example:

• Policies to reduce unemployment
• Policies to reduce inflation

If economics can contribute to reducing unemployment, then it can make a significant improvement to economic welfare. For example, the mass unemployment of the 1930's great depression led to political instability and the rise of extremist political parties across Europe.

However, the problem is that economists may often disagree on the best solution to these challenges. For example, at the start of the great depression in 1930, leading economists in the UK Treasury suggested that the UK needed to balance the budget; i.e. higher taxes, lower unemployment benefits. But, this made the recession deeper and led to a fall in demand.

It was in the great depression that John Maynard Keynes developed his general theory of Employment, Income and Money. He argued that classical economics had the wrong approach for dealing with depressions. Keynes argued that the economy needed expansionary fiscal policy. - higher borrowing and government spending.

2. Overcoming Market Failure

Market failure - stuck in traffic jam, breathing car fumes

It is considered that free markets offer a better solution than a planned economy (Communist) However, free markets invariably lead to problems such as

• The over production of negative externalities (e.g. pollution/congestion)
• The underproduction of goods with positive externalities (e.g. education, health care, public transport).
• Non-provision of Public Goods - (national defence, law and order)

An economist can suggest policies to overcome these types of market failures. For example

• Tax negative externalities
• Subsidise public services like health care and education.

The importance of economics is that we can examine whether society is better off through government intervention to influence changes in the provision of certain goods.

Some topical issues economists are concerned with

• Carbon Tax - should we implement a carbon tax to reduce global warming?
• Should we tax fatty foods?

Efficiency

Another area where economists have a role to play is in improving efficiency. For example economists may suggest supply side policies to improve the efficiency of an economy.

Individual Economics

Economics is also important for an individual. For example, every decision we take involves an opportunity cost - which is more valuable working overtime or having more leisure time?
In recent years, behavioural economics has looked at the diverse range of factors that influence people's decisions. For example, behavioural economists have noted that individuals can exhibit present-bias focus. This means placing excess importance on the current time period and making decisions our future self may regret. This includes over-consumption of demerit goods like alcohol and tobacco and failure to save for a pension.

Efficiency v Equity

In classical economics, we often focus on maximising income and profit. However, this is a limited use of economics. Economics is also concerned with maximising overall economic welfare (how happy are people). Therefore economics will help offer choices between increasing output and reducing inequality.

• Efficiency v equality
• GDP and Happiness

Economics of daily living

In recent years, economists such as Gary Becker have widened the scope of economics to include everyday issues, such as crime, family and education and explained these social issues from an economic perspective. Becker places emphasis on the theory of rational choice. The idea that individuals weigh up costs and benefits.
See: Applying economics in daily life

Conclusion

Economics is important for many areas of society. It can help improve living standards and make society a better place. Economics is like science in that it can be used to improve living standards and also to make things worse. It partly depends on the priorities of society and what we consider most important.

Issues to Further Study the Importance of Economics

• Economics - The Dismal Science
• How to deal/combat global warming?
• Does globalisation help or hinder developing countries?
• How to live in a society without oil?

Have Your say

Leave a comment, if you would like to make a suggestion on the importance of economics in your daily life.

Run on the Pound

A run on the pound refers to a situation where international investors become nervous over holding sterling and sterling assets, and so sell as quickly as possible.

A run on the pound may occur when markets feel the Pound is overvalued and likely to fall quickly. If markets expect the pound to fall, they will sell quickly before making a loss.

What may cause a run on the Pound?

• A run on the pound is more likely in a semi fixed exchange rate. e.g. when the Government is committed to trying to keep the Pound at a certain level. If markets feel this level is unsustainable they may keep selling Pounds until the government is forced to devalue.

• For example, in 1992, the UK tried to maintain value of Sterling in ERM, but, ultimately markets forced the UK out and we had to devalue. The graph above shows the near 20% devaluation in 1992.
• We also had a run on the pound in the late 60s, causing the Wilson government to devalue pound. (In 1967, Wilson devalued pound by 15% after selling many foreign currency reserves trying to maintain value of Pound)
• In 1976, there was another on the Pound as markets feared the UK's fiscal position.
• Financial crisis depreciation. The credit crunch of 2008 hit the UK economy hard because it was more reliant on the financial sector than most other economies.

Other potential causes of a run on the Pound

• High inflation - high inflation reduces the value of Pound Sterling. Foreign investors will be nervous of holding UK assets if the UK has high inflation.
• Threat of sovereign debt default. If markets feel government borrowing is too high and unsustainable then there is a risk of foreigners losing their government bonds. Therefore, the market will sell bonds causing an outflow of foreign currency and fall in value of sterling. This can build up a momentum effect. As the fall in the currency can alarm other investors.
• Large current account deficit. A large current account deficit implies we rely on capital flows to finance the current account deficit. Therefore, the UK would be more vulnerable to capital flight. In this circumstance a run on the Pound would be stronger. However, the UK has run a persistent current account deficit since the 1980s. (See: Current account deficit)

Is the UK at risk from a Run on the Pound?

No. Firstly the Pound is floating i.e. governments are not trying to keep its value high. The Pound has already depreciated by about 15% since the Brexit vote in June 2016. - This wouldn't count as a run on the pound but large depreciation. With a floating exchange rate, there is less chance of markets feeling an exchange rate is fundamentally overvalued.

UK's debt is a concern (national debt at over 80% of GDP), but, we still retain good credit rating and despite rising debt, bond yields fell - reflecting the fact markets see UK debt as a safe investment. 

Would membership of Euro protect against a run on the Pound?

If we joined the Euro, by definition we couldn't have a run on the Pound, but, it doesn't solve underlying problems like lack of competitiveness, excessive government borrowing, negative growth. Being outside the Euro, would give Greece more flexibility for dealing with their crisis.

Related

• Falling value of Pound Sterling
• Depreciation in Sterling
• Why Pound Sterling is falling

Link between inflation and interest rates

• Interest rates can influence the rate of inflation and the rate of economic growth.
• The Bank of England change the 'base' interest rate to try and target the government's inflation rate of 2% +/-1

• Generally, an increase in inflation leads to higher interest rates.
• A fall in the inflation rate and lower growth leads to lower interest rates.

Graph Showing Inflation and Interest Rates in the UK

Real Interest Rates

• Typically, nominal interest rates are 1 - 2 % higher than inflation. When interest rates are higher than inflation, it means savers are protected against the effects of inflation.
• However, in 2008 and 2011, we had a period of negative real interest rates. This meant the inflation rate was higher than the base rate.
• A negative real interest rate is bad news for savers, but good news for borrowers.

Response to Rising Inflation

• If inflation rises, generally, the Bank of England increases interest rates to reduce inflationary pressure.
• Higher interest rates tend to reduce consumer spending. This is because homeowners see an increase in the cost of their mortgage payments and have less disposable income. Therefore, they spend less. Also, higher interest rates increase the incentive to save and reduce the incentive to borrow.
• Therefore, an increase in interest rates tends to reduce the rate of economic growth and prevent inflationary pressures.
• See more on: Effects of Higher interest rates on economy

Response to Fall in Inflation Rate

If inflation falls below the target, there is likely to be a fall in the rate of economic growth, and the Central Bank may fear a recession. Therefore, in response, they may cut interest rates to try and boost economic growth.

• Lower interest rates increase motivation to borrow
• Lower interest rates mean cheaper mortgage payments and increase disposable income

Why A Cut in Interest Rates May Not Work

In some situations, cutting interest rates may be ineffective in boosting economic growth. For example, in 2008-11:

• The recession was so sharp that investment and consumption have fallen dramatically and so the cuts in interest rates have only mitigated the extent of the downturn
• House Price falls provide a powerful negative impact on spending. Lower interest rates should boost spending. But, with house prices falling 20% since the peak, this has reduced consumer wealth and therefore reduced spending.
• Global downturn. Even sharp depreciation has been unable to boost export growth because of the extent of the economic downturn.
• Time Lags. A cut in interest rates can take a long time to have an effect. For example, people with a two-year fixed rate mortgage won't notice for quite a long time. (until they re-mortgage. Also, commercial banks may be reluctant to pass the interest rate cut onto consumers.

Why higher inflation may not cause higher interest rates

• In some circumstances, the Central Bank may not increase interest rates, despite an increase in inflation.
• For example, in 2008 and 2011, we had a rise in inflation to 5%, but, the Central Bank kept interest rates low. Why?

They kept interest rates low because:

• They felt inflation was just due to temporary cost-push factors like higher taxes and volatile food prices increasing
• They felt economy was at risk of inflation. Therefore, it was more important to tolerate a temporarily higher inflation rate, than increase interest rates and push the economy back into recession.

Related

• Interest rates and the economy
• Latest interest rate and inflation predictions
• Does low inflation always mean low-interest rates?
• Real Interest rates
• Understanding interest rates

UK Exchange Rate Mechanism Crisis 1992

In October 1990, the UK made the decision to join the Exchange Rate Mechanism (ERM)
The ERM was a semi-fixed exchange rate mechanism. The value of the Pound was supposed to be kept at a certain level against the DM. £1 = DM2.95. The lower limit for the exchange rate was DM 2.773. If the Pound approached this level, the government would be obliged to intervene - through buying Pounds and raising interest rates.

The exchange rate mechanism was designed as a precursor to joining the Euro. The aim was to keep exchange rates stable; it was hoped this would:

• Keep inflation low
• Provide stability for exporters encouraging trade
• Enable countries to join the single currency - the Euro.

In the late 1980s, the chancellor, Nigel Lawson was keen to join the ERM. But, Mrs Thatcher with her more euro-sceptic views wanted to stay out. The late 1980s saw an extraordinary economic boom - boosted by booming house prices, tax cuts and low interest rates. Growth reached record levels of 4-5% a year. Enthusiastic government ministers talked of an economic miracle - hoping Government policies had enabled, at long last, to catch up with other countries like Germany.

Economic growth

However, this miracle was an illusion. High growth was unsustainable and led to inflation.(see: Lawson Boom) With inflation of 10%, Nigel Lawson was able to convince Mrs Thatcher that the UK would benefit from joining the ERM to help reduce inflation.




Therefore, the UK joined in October 1990. at a rate of DM 2.95 to the Pound.

However, the problem was that the economic situation was declining quickly. The UK was sliding into recession due to falling house prices and an end to the past economic boom.



High inflation and deteriorating economic activity was making the Pound less attractive. Therefore, the Pound kept falling to its lower limit in the ERM. Therefore, the government was bound to protect this value of the Pound by:

• Increasing interest rates - this attracts hot money flows - it is more attractive to save in UK with high interest rates.
• Buying pounds with foreign exchange reserves.

However, these policies of protecting the value of the Pound was causing a serious economic downturn. High interest rates particularly hit the housing market. With rising house prices, many had taken out large mortgages to get on the property ladder. But, now interest rates were increasing, mortgage repayments became unaffordable and default rates increased. Combined with rising unemployment from the recession, the housing market saw a dramatic fall in prices that was to last 4 years.




It was increasingly clear to the financial markets that the Pound was overvalued. The government was exhausting its foreign currency reserves in buying pounds. But, more problematically, the high interest rates was causing a serious recession and misery for homeowners.

Financial speculators like George Soros predicted the Pound was doomed, so they were keen to sell their pounds to the British government. (It is said George Soros made £1 billion out of the UK government during ERM crisis)

It became a question of pride for Ministers, with Norman Lamont and John Major pledging to keep the UK in the ERM, seemingly at all costs.

For a long time, the British government fought a losing battle. But, the foreign currency reserves of the British government were no match for the trillions of Pound Sterling traded on the foreign currency and the pound kept sliding. It is estimated that the Treasury used £27 billion of foreign currency reserves trying to prop up the Pound. The Treasury estimated the final cost to the taxpayer was estimated at £3.4 billion.

On one desperate day - Wednesday 16th September, the UK government increased interest rates to 15%. In theory, these high interest rates should attract hot money flows. But, the market saw it for what it was - a measure of desperation. The market knew these interest rates were unsustainable and couldn't be maintained; the sell off continued and eventually, the government caved into the inevitable and left the ERM. The Pound fell 15%, interest rates were cut, and the economy was able to recover.

It is a classic example, of failed government policy. If the UK had joined the ERM at the start of the economic boom in the mid 1980s, the anti inflationary impact would have helped moderate the boom, kept inflation low and prevented a painful readjustment. But, they joined at the wrong rate at the wrong time. Trying to keep the Pound artificially high caused a recession, deeper than any of our competitors.  The ERM was dubbed 'The eternal recession mechanism'. The artificially high exchange rate just attracted financial speculators who saw the British government as a source of easy profit.

On leaving the ERM, the UK economy soon recovered. This was partly due to devaluation, but also perhaps more importantly - interest rates were able to fall significantly.

However, the episode left painful scars and played a key role in keeping the UK out of the Euro. It also shows the mistake of targeting inflation through an intermediary such as the exchange rate. As a consequence of this episode, the government gave the Bank a direct inflation target of 2.5%. The ERM crisis also paved the way to given the Bank of England independence in 1997. The hope was that an independent bank would avoid the excesses of the Lawson boom and bust of the 1980s.

Lessons from ERM

• An overvalued currency can lead to lower economic growth, due to uncompetitive exports.
• Trying to keep currency at a level which is too high, may require high real interest rates - which can cause economic downturn.
• It is hard to buck the market. Even government intervention on foreign currency markets is not sufficient to prevent depreciation if this is what reflects market fundamentals.
• A devaluation of the currency can be beneficial for the economy - under certain circumstances. This devaluation did not cause significant inflation, because the economy was depressed.

Related

• UK Recession of 1991-92
• UK devaluation of 1967 - many similarities 
• UK Economic history
• Factors influencing exchange rate
• UK Crashes out of ERM in 1992 at BBC
• "Unemployment is a price well worth paying for lower inflation" - Norman Lamont commenting on his own policies

 

Benefits of the European Union

The European Union is a political and economic union of 28 countries. Originally formed in 1958 by six countries (then the EEC), the EU has expanded in terms of size and integration. The aim of the EU is to promote European harmony through creating a single market, enabling the free movement of goods, services and people.

Some of the benefits of the European Union include:

Broad political and legal benefits

1. European harmony - European Union countries are no longer at loggerheads like they were in the past. With the exception of civil war in Yugoslavia (which wasn't in the EU at the time), Europe has managed to heal the divisions which were so painfully exposed in the two World Wars in the Twentieth Century. The EU was awarded the Nobel Peace Prize in 2012 for helping to promote peace and international co-operation. Many Eastern European countries are keen to join the EU because they feel it will help promote economic and political stability.
2. Legal and human rights. The EU has a strong commitment to human rights, preventing discrimination and the due process of law. This makes the EU attractive to countries, such as the Ukraine who wish to share in similar legal and human rights.
3. Prospect of membership has helped modernise countries, such as Turkey. The Copenhagen Criteria for EU membership enshrine a commitment to human rights, the rule of law and a market economy. The prospect of gaining membership of the EU, encourage countries to implement human rights legislation.

Economic benefits

1. EU is one of strongest economic areas in the world. With 500 million people, it has 7.3% of the world's population but accounts for 23% of nominal global GDP.
2. Free trade and removal of non-tariff barriers have helped reduce costs and prices for consumers. Increased trade with the EU creates jobs and higher income. Over 52% of UK exports are to the EU. Trade within the EU has increased 30% since 1992.
3. According to one study - over ten years (1993-2003), the Single Market has boosted the EU’s GDP by €877 billion [£588 billion]. This represents €5,700  [£3,819] of extra income per household.
4. A paper, Campos, Coricelli, and Moretti (2014) used the synthetic counterfactuals method (SCM) pioneered by Abadie and Gardeazabal (2003). The red dotted line shows estimated GDP if the country had not been a member of the EU. This shows that even more prosperous EU countries, such as the UK have benefited from higher GDP as a result of being in the EU.
   
   
5. Removal of customs barriers mean 60 million customs clearance documents per year no longer need to be completed, cutting bureaucracy and reducing costs and delivery times
6. Countries in the EU, are amongst the highest positions in the Human Development Index (HDI)
7. Poorer countries, such as Ireland, Portugal and Spain have made significant degrees of economic development since they joined the European Union. A report suggests that over the period of the 1980s and 2004 enlargement, there are substantial positive payoffs of EU membership, with a gain in per capita GDP of approximately 12% for poorer countries. (Vox - how poorer countries benefit from EU)
8. Social cohesion fund. This has invested in poorer areas of the EU to help reduce regional disparities. For example, Ireland benefited from the EU social cohesion fund (over €6 billion of investment in education and infrastructure spending)
9. EU structural funds to help Eastern European economies develop will benefit the UK in the long term because as they become more affluent, they will be able to buy more UK exports.
10. The European Union has attracted greater inward investment from outside the EU. Inward investment grew from €23 billion  [£15.4 billion] in 1992 to €159 billion [ £106.5 billion] in 2005. The UK is the 5th largest source of inward investment in the world, and being a member of the single market is an important factor in encouraging Japanese firms.
    
    he European Social Fund (ESF)

Labour and free movement of people

1. Free movement of labour and capital have helped create a more flexible economy. For example, UK and Ireland have benefited from the immigration of Eastern European workers to fill labour market shortages in certain areas, such as plumbing, nursing and cleaning. 
2. Far from 'taking jobs', migration has helped increase productive capacity and makes a net contribution to tax revenues. (see impact of net migration)
3. Free movement of labour also enables British people to live and work in Europe. Roughly 1.6 million British citizens live in the EU outside the UK (UNCTAD World Investment Report 2010)
4. EU migrants are net contributors to UK Treasury. EU migrants tend to be young. Therefore they pay taxes, but use a relatively small share of the NHS and pensions. See: Fiscal effects of immigration. Net migration has helped deal with the UK's demographic timebomb.
5. EU has enabled people to travel freely across national boundaries making trade and tourism easier and cheaper. According to the European Commission, more than 15 million EU citizens have moved to other EU countries to work or to enjoy their retirement.
6. 1.5 million young people have completed part of their studies in another member state with the help of the Erasmus programme. The possibility to study abroad is considered positive by 84% of EU citizens. (benefits of EU)
7. Easier to use qualifications in different member countries. This makes it easier to work abroad without having to retrain in different national qualifications.
8. Mutual recognition of safety standards and rules have helped reduce costs for firms. This has encouraged the development of small and medium business who rely on the low cost of exports.
9. Social charter enshrines protection for workers such as a maximum working week, right to collective bargaining and fair pay for employment. 
10. European Arrest Warrant (EAW) scheme has made it easier to track criminals across the European continent.

Environmental benefits of the EU

• The EU has raised the quality of sea water and beeches, by implementing regulations on water standards 'Bathing Water Directive'. 92% of tourist locations now meet minimum water quality standards. (Clean water at Europa.eu)
• Tackling global warming. In 2006, the (EU) committed to reducing its global warming emissions by at least 20 percent of 1990 levels by 2020. The EU has also committed to spending $375 billion a year to cut greenhouse gas emissions by at least 80 percent by 2050 compared to 1990 levels. (global warming pdf)
• Tackling acid rain. Environmental treaties which have sought to deal with European wide environmental problems such as acid rain. The EU has set strict restrictions on emissions of pollutants, such as sulphur, and other causes of acid rain. (BBC Link)

Consumer benefits of the EU

• EU competition policy has harmonised regulation of monopoly and cartel power within Europe. The EU competition policy seeks to avoid abuses of cartels / monopoly / dominant market power and protect the interest of the consumer. There has been successful deregulation of airlines, electricity and gas markets.
• The EU has reduced the price of making mobile phone calls abroad. In 2007 EU legislation set maximum charges for making and receiving calls.  The EU also agreed with 14 mobile phone manufacturers to create a standard design for chargers from 2011 in order to make life easier for consumers and reduce wastage. In 2014, it is has voted to scrap roaming charges which will drastically reduce the cost of using a mobile phone abroad. (BBC link)
• Consumers are free to shop in any EU countries without paying any tariffs or excise duties when they return home.

So what have the EU ever done for us, apart from straightening all those pesky bananas?

Of interest 

• Costs and benefits of the EU in perspective

Related

• Economic problems of the European Union
• Disadvantages of EU
• Problems of Euro

Recent posts on Brexit and Europe

Just in case you still follow this blog, I have been blogging alot at economicshelp.org/blog

Recent posts

• Problems facing UK economy post Brexit
• Policies to deal with free movement of labour
• Dealing with Brexit
• What they didn't tell you during referendum debate
• Advantages of free movement of labour
• Will Brexit cause recession?
• Winners and losers from weak Pound
• Costs and benefits of EU in perspective
• Economic effect of immigration on NHS
• Creative destruction

Advantages and disadvantages of WTO

Readers Question: What are the advantages and disadvantages of the WTO formally the GATT?

The WTO is a body designed to promote free trade through organizing trade negotiations and act as an independent arbiter in settling trade disputes. To some extent the WTO has been successful in promoting greater free trade. The principles of the WTO are

1. Promote free trade through gradual reduction of tariffs
2. Provide legal framework for negotiation of trade disputes. This aims to provide greater stability and predictability in trade.
3. Trade without discrimination - avoiding preferential trade agreements.
4. WTO is not a completely free trade body. It allows tariffs and trade restrictions under certain conditions, e.g. protection against 'dumping' of cheap surplus goods.
5. WTO is committed to protecting fair competition. There are rules on subsidies, dumping
6. WTO is committed to economic development. For example, recent rounds have put pressure on developed countries to accelerate restrictions on imports from the least-developing countries.

Advantages of promoting free trade

1. Lower prices for consumers. Removing tariffs enables us to buy cheaper imports
2. Free trade encourages greater competitiveness. Through free trade, firms face a higher incentive to cut costs. For example, a domestic monopoly may now face competition from foreign firms.
3. The law of comparative advantage states that free trade will enable an increase in economic welfare. This is because countries can specialise in producing goods where they have a lower opportunity cost.
4. Economies of scale. By encouraging free trade, firms can specialise and produce a higher quantity. This enables more economies of scale, this is important for industries with high fixed costs, such as car and aeroplane manufacture. In new trade theory, it is this specialisation and exploitation of economies of scale that is most important factor in improving economic welfare. See also: Advantages of Free Trade

Successes of WTO

To what extent has the WTO being able to promote free trade?

• The WTO has over 160 members representing 98 per cent of world trade. Over 20 countries are seeking to join the WTO. 
• An increased number of trade disputes have been brought to the WTO, showing the WTO is a forum for helping to solve disputes.
• WTO regulations and co-operation helped avoid a major trade war; this was significant during 2008/09 global recession. We could compare this to 1930s, where trade wars broke out causing a fall in global trade. According to (Bagwell and Staiger 2002) the average tariff in 1930s was 50%. In 2000s, average tariff is 9% (VOX)
• According to Ralph Ossa, "WTO success: No trade agreement but no trade war"
  VOX.eu  11 June 2015. the value of WTO in preventing trade wars could be estimated at up to $340 billion per year.

 

World exports as a % of GDP have increased from 22% of GDP in 1995 (when WTO formed to just under 30% in 2015. Indicating importance of trade to global economy.

Disadvantages of WTO

• However, the WTO has often been criticised for trade rules which are still unfavourable towards developing countries. Many developed countries went through a period of tariff protection; this enabled them to protect new, emerging domestic industries. Ha Joon Chang argues WTO trade rules are like 'pulling away the ladder they used themselves to climb up' (Kicking away the ladder at Amazon)
• Free trade may prevent developing economies develop their infant industries. For example, if a developing economy was trying to diversify their economy to develop a new manufacturing industry, they may be unable to do it without some tariff protection.
• WTO is being overshadowed by new TIPP trade deals. These deals are negotiated away from WTO and focuses mainly on US and EU. It excludes China, Russia, India, Brazil and South Africa. It threatens to diminish the global importance of WTO
• Difficulty of making progress. WTO trade deals have been quite difficult to form consensus. Various rounds have taken many years to slowly progress. It results in countries seeking alternatives such as TIPP or local bilateral deals.
• WTO trade deals still encompass a lot of protectionism in areas like agriculture. Protectionist tariffs which primarily benefit richer nations, such as the EU and US.
• WTO has implemented strong defense of TRIPs ‘Trade Related Intellectual Property’ rights These allow firms to implement patents and copyrights. In areas, such as life-saving drugs, it has raised the price and made it less affordable for developing countries.
• WTO has rules which favour multinationals. For example, 'most favoured nation' principle means countries should trade without discrimination. This has advantages but can mean developing countires cannot give preference to local contractors, but may have to choose foreign multinationals - whatever their history in repatriation of profit, investment in area.

Evaluation

• In response to this the WTO may say that free trade has been an important engine of growth for developing countries in Asia. Although there may be some short term pain, it is worth it in the long run.
• Also the WTO has sought to give exemptions for developing countries; enabling in principle the idea developing countries should be allowed to limit imports more than developed countries.

• Disadvantages of free trade
• WTO
• WTO at Make Poverty History