Wednesday, June 9, 2021

Why Deflation is Bad

Deflation is a situation where prices fall (negative inflation rate)
    Deflation in the UK in the 1920s.

There are several reasons why deflation is considered to be harmful to the economy.

  1. Discourage buying. When general prices are falling, consumers tend to delay purchasing. For example, rather than buy a flatscreen today, they wait a year when they will be cheaper. The effect of falling prices is to depress consumer spending leading to lower economic growth.
  2. Increasing real value of debt. When people take on debt like mortgages, they expect the value of the debt to be steadily eroded by inflation. (A mortgage becomes easier to repay as your wage increases). When there is deflation, the real value of debts increases. You owe the same, but, your wage is falling. Therefore, you have to spend a higher % of your income on servicing the deb.

    The increasing real value of debt can cause a deflationary spiral. As prices fall and debt increases, it leads to lower confidence, lower spending (lower AD) and this leads to a further fall in prices and wages.

  3. Increasing Government Debt to GDP ratio. Deflation also increases the real value of government debt. It makes it much more difficult to reduce the debt to GDP ratio. Thus countries can start spending a higher % of income on debt repayment. Furthermore, as deflation tend to reduce economic growth, the cyclical deficit increases. The lack of growth of nominal GDP was a key factor behind the increase in debt to GDP in Greece, during the debt crisis of 2010s. In the UK in the 1920, deflation kept debt to GDP above 100% of GDP for two decades.

  4. Real Wage Unemployment. In deflation, wages may need to fall so firms can afford to keep employing workers. However, wages are often sticky downwards. (Unions resist nominal wage cuts). Therefore, falling prices are often not met by falling wages this leads to a rise in real wages. This creates real wage unemployment. It also makes a countries exports less competitive (particularly a problem in the Eurozone where countries can't devalue the exchange rate)

    Demand for labour falls to D2 causing equilibrium wage to fall to W2. But, if wages are sticky downwards they remain at W1 causing unemployment of Q3-Q1.

  5. Monetary Policy Becomes ineffective. With deflation, zero interest rates may be too high. Even quantitative easing may be insufficient to get people spending. (deflation and monetary policy)  The problem is that it is difficult to cut interest rates below zero and so the monetary authorities cannot adequately deal with the slow growth and deflation.
Further Reading

Friday, March 20, 2020

How much can the government borrow?

In 2020, the impact of the coronavirus and partial economic shutdown will cause a substantial and unprecedented increase in government borrowing. It will severely test the question of how much the government can borrow. There are a few quick points worth bearing in mind.
  • Historical precedents. In WWII, the OBR said the UK ran a budget deficit of nearly 27% of GDP. By the early 1950s, UK national debt had risen to 240% of GDP. Yet this was not a significant problem. In the post-war period, the UK enjoyed a long period of economic expansion, where debt to GDP ratios fell. In March 2020, UK debt to GDP ratio was around 80% of GDP, so there is significant room for an increase in government debt.
Source: Reinhart, Camen M. and Kenneth S. Rogoff, “From Financial Crash to Debt Crisis,” NBER Working Paper 15795, March 2010. and OBR from 2010.
  • Government's have the ability to create money. Some economists (especially those believing in MMT) argue the only constraint to government borrowing is inflation. In other words, higher government spending financed by printing money is only a problem when it causes inflation. In a severely depressed economy, with inflation falling (and possibly deflation) it maybe desirable for the government to create money and target a positive inflation rate. In 2009/10 recession, US and UK financed some borrowing through quantitative easing.
  • In a recession, most economists accept that a rise in government borrowing is necessary to offset the fall in private sector investment and spending. Keynesian economics says expansionary fiscal policy can help an economy recover. But austerity (cutting spending) can make the recession worse, worsening tax revenues and be counter-productive in cutting borrowing.
  • During a period of economic growth when the economy is close to full capacity, government borrowing can cause many problems such as crowding out of the private sector, pushing up interest rates, and possible inflationary pressures.
The amount a government can borrow depends on many factors, such as
  • Does it print its own currency?
  • Do markets trust the government to maintain low inflation and not default?
  • What are the interest rate on government bonds?
  • What is the state of the economy?
  • What is the purpose of government borrowing?
  • To what extent is the government borrowing from domestic or foreign investors?

Levels of government debt

At times government debt has been very high:
  • US 117% of GDP in 1945 (gross federal debt (1)
  • UK 240% of GDP in the early 1950s 
  • Japan has national debt over 230% GDP

    How does the government finance its debt?

    1. Selling government bonds to the private sector - either domestic or foreign. The private sector buy bonds because the security and interest rate on them.
    2. The Central Bank can finance shortfall in revenue by increasing the money supply and buying bonds itself. This is sometimes known as quantitative easing.

    Factors which influence how much a government can borrow

    • Domestic savings. If consumers have a high savings ratio, there will be a greater ability for the private sector to buy bonds. Japan has very high levels of public sector debt, but with high domestic savings, there has been a willingness by the private sector to buy the government debt. Similarly, during the Second World War, the government was able to tap into the high levels of domestic savings to finance UK debt. 
    This shows that the rise in government borrowing in 2009/10 recession mirrored the rise in private sector savings.
    • In a depression, we tend to see a rise in private sector saving (the paradox of thrift) because households fear being made unemployed and firms don't want to invest. Therefore, in a recession, there is often surplus private sector savings. A surplus of unused savings means there is an advantage for the government to borrow, invest, create jobs and make use of these surplus savings. As Greg Mankiw said in March 2020. "There are times to worry about the growing government debt. This is not one of them."
    • Relative interest rates. If government bonds pay a relatively high-interest rate compared to other investments, then ceteris paribus, it should be easier for the government to borrow. Sometimes, the government can borrow large amounts, even with low-interest rates because government bonds are seen as more attractive than other investments. (e.g. in a recession government bonds are often preferred to buying shares (which are more vulnerable in a recession). This is why US bond yields fell 2008-11, despite growth in US government borrowing. 
    UK bond yields fell during a period of rising debt 

    This shows that during a period of higher government borrowing 36% of GDP increasing to 80% of GDP - bond yields fell from 9% to 2%

    • Lender of last resort. If a country has a Central Bank willing to buy bonds in case of liquidity shortages, investors are less likely to fear a liquidity shortage. If there is no lender of last resort (e.g. in the Euro during 2011/12) then markets have a greater fear of liquidity shortages and so are more reluctant to buy bonds.
    • Confidence and security. Usually, governments are seen as a safe investment. Many governments have never defaulted on debt payments so people are willing to buy bonds because at least they are safe. However, if investors feel a government is too stretched and could default, then it will be more difficult to borrow. Therefore, some countries like Argentina with bad credit histories would find it more difficult to borrow more. Political uncertainty can make investors more concerned.
    • Foreign Purchase. A country like the US attracts substantial foreign buyers for its debt (Japan, China, UK). This foreign demand makes it easier for the government to borrow. However, if investors feared a country could experience inflation and a rapid devaluation, foreigners would not want to hold securities in that country and it could lead to capital withdrawal.
    • Inflation. Financing the debt by increasing the money supply is risky because of the inflationary effect. Inflation reduces the real value of the government debt, but, that means people will be less willing to hold government bonds. Inflation will require higher interest rates to attract people to keep bonds. In theory, the government can print money to reduce the real value of debt; but existing savers will lose out. If the government creates inflation, it will be more difficult to attract savings in the future. A crucial factor is whether inflation is likely. In a recession, inflationary pressures vanish so it is much easier to finance a deficit by borrowing.

    Why did Eurozone countries experience more debt problems than UK and US in 2012?


    Bond yields in Italy, increased despite Italy having a primary budget surplus. This was a similar story for other countries in the Euro. One issue is that (between 2011 and 2013) Italy had no Central bank willing to act as a lender of last resort. See more reasons for Italian Debt Crisis

    However, when the ECB agreed to effectively intervene in the bond market, bond yields fell.


    Wednesday, March 11, 2020

    Paradox of Thrift

    • The paradox of thrift is a concept that if many individuals decide to increase their private saving rates, it can lead to a fall in general consumption and lower output.
    • Therefore, although it might make sense for an individual to save more, a rapid rise in national private savings can harm economic activity and be damaging to the overall economy.
    • In a recession, we often see this 'paradox of thrift'. Faced with the prospect of recession and unemployment, people take the reasonable step to increase their personal saving and cut back on spending. However, this fall in consumer spending leads to a decrease in aggregate demand and therefore lower economic growth.

    Paradox of thrift during 2020 corona recession

    • In 2020, the economic shutdown will lead to an unprecedented rise in savings. Partly because people are very nervous about the future economy but also because opportunities to spend are severely limited.
    • On the other hand, people who see a large fall in income will have to dip into their savings and borrow to stay afloat.

    Paradox of thrift during 2009 Recession

    In the recession of 2008, we see a sharp rise in the UK saving ratio as consumers respond to bad economic news by increasing saving and cutting back on spending.
    This fall in spending and a rise in saving contributed to the recession.

     A deep recession in 2008/09 partly magnified by a rise in private sector saving.

    Paradox of Thrift in 1930s

    In the great depression of the 1930s, GDP fell, unemployment rose and the UK experienced a long period of deflation. In response to this disastrous economic situation, mainstream economists were at a loss as how to respond. Such a lengthy period of disequilibrium didn’t sit well with Classical theory which expected markets to operate smoothly and efficiently.

    One policy the National government did approve was the cutting of unemployment benefits. The rationale was that in times of depression the govt should set an example by reducing its debt. This example actually inspired members of the public to send in their savings in the hope that it would help the economy.

    By reducing benefits they further reduced consumer spending and AD. This made areas of high unemployment even more impoverished. When people saved rather than spent their money it just made the recession worse.

    Keynes and paradox of thrift

    In the 1930s, J.M. Keynes argued that this 'paradox of thrift' was pushing the economy into a prolonged recession. He argued that in response to higher private saving, the government should borrow from the private sector and inject money into the economy.

    This government borrowing wouldn't cause crowding out because the private sector were not investing, but just saving.

    In the UK and US Keynes was largely ignored until after the war and as a consequence the UK economy experienced high levels of unemployment for the remainder of the decade.

    Who coined the term paradox of thrift?

    Keynes first popularised the term as it fitted in neatly with his concept that recessions were caused by falls in aggregate demand. It also justified higher government borrowing to offset the private sector savings. He mentioned it in his General Theory.
    "For although the amount of his own saving is unlikely to have any significant influence on his own income, the reactions of the amount of his consumption on the incomes of others makes it impossible for all individuals simultaneously to save any given sums. Every such attempt to save more by reducing consumption will so affect incomes that the attempt necessarily defeats itself. It is, of course, just as impossible for the community as a whole to save less than the amount of current investment, since the attempt to do so will necessarily raise incomes to a level at which the sums which individuals choose to save add up to a figure exactly equal to the amount of investment.
    — John Maynard Keynes, The General Theory of Employment, Interest and Money, Chapter 7, p. 84
    This rather long-winded statement was shortened by Paul Samuelson, who used the term 'paradox of thrift' in his influential post-war macroeconomics text book.

    The idea was also in use before Keynes. In 1893, in the The Fallacy of Saving, John M. Robertson writes on the potential problem of many individuals saving at once.
    "Had the whole population been alike bent on saving, the total saved would positively have been much less, inasmuch as (other tendencies remaining the same) industrial paralysis would have been reached sooner or oftener, profits would be less, interest much lower, and earnings smaller and more precarious. This ... is no idle paradox, but the strictest economic truth."
    — John M. Robertson, The Fallacy of Saving, pp. 131–132

    Paradox of thrift and government borrowing

    The paradox of thrift suggests that if there is a recession, there will be a rise in private sector saving and hence greater demand to buy government bonds. Therefore, even if the government borrow more, bond yields may fall.

    Criticisms of paradox of thrift

    1. Higher saving increases bank balances and can lead to an increase in bank lending - and hence investment.
    2. A fall in demand from higher saving, will cause lower prices, which encourage demand to increase. This is related to Say's Law which states supply creates its own demand.
    3. Higher domestic savings can lead to lower domestic inflation and therefore increase exports. Higher exports can boost demand.

    Responding to criticisms

    1. In a recession, banks may not want to lend, and even if banks do want to lend, firms do not want to borrow and invest. In fact, in a recession, firms may do the same as consumers and try to save more and pay back dent. 
    2. Prices may be sticky downwards and not fall, even if there is lower demand. Also, if prices fall, deflation can discourage spending because real value of debt rises.
    3. Not every country can 'export' its way out of a recession.


    Friday, June 14, 2019

    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

    Monday, May 13, 2019

    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.


    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.


    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


    Friday, March 8, 2019

    7 Common Economic Fallacies

    Some common economic fallacies, such as 'immigrants take our jobs' the broken window fallacy and the Luddite fallacy on the role of new technology.

    1. Immigration causes Unemployment.
    It is an argument often repeated. It goes something like this. “Immigrants who come over here are willing to work for lower-paid jobs and thus they create unemployment for local people.”

    This argument is wrong because.
    • Immigrants increase the supply of labour but they also increase aggregate demand in the Economy. This means that they buy more goods and create additional demand in the economy. They provide labour supply and increase labour demand.
    • If immigration caused unemployment why did America not have high unemployment during times of mass immigration? Because the immigrants created as many jobs as they took.
    • Often immigrants take jobs that native workers just don’t want to do. – You won’t see big multinationals cueing up to stop immigration.
    • Furthermore, immigrants tend to be of working age. Therefore they tend to contribute more tax than receive in benefits. Without immigration, US demographics would have a larger % of dependent old people.

    2. House Prices in London will keep rising because of a shortage of supply.

    True there is a shortage of supply in big cities like London and New York. However, this doesn’t mean house prices will always keep on rising. House prices can fall just like anywhere else. It just means that they will be higher on average than elsewhere in the country. Note house prices in Tokyo and Japan fell over 25% after the end of the speculative bubble in the 1980s. – American house prices have a lot further to go.

    3. War is good for the economy

    This fallacy is deeply embedded in many people’s mind. One reason is that it was felt the Second World War ended mass unemployment in the US and UK. To some extent, it is true unemployment fell because of the Second World War. However, war is not necessary to solve unemployment. The government could have intervened to create jobs through public work schemes.
    • War does create more output, but only in some industries related to war. Arms manufacturers do very well out of the war. But the total output of the economy doesn’t increase instead there is a change in economic priorities. Resources are diverted from peaceful industries to industries for creating the mechanisms of war.  This is similar to the broken window fallacy.
    • If a butcher's window is smashed, the window repairer sees new work. He gains more income. But, the broken window hasn't increased economic welfare. It just means the butcher has to spend money repairing a window rather than investing in a bigger premise.
    • Increase in government spending for wars create either taxes and or higher debt payments. This is a burden on current and future taxpayers. Note The UK is still paying off debt from second world war.

    4. Tax Cuts make people work harder
    • Ronald Reagan’s economic advisers told him something along the lines of “cut taxes” and you can increase total tax income. This theory is based on the laffer curve which states that if taxes are 100% people won’t work. Therefore if you cut taxes more people work and you can increase tax revenue. This is based on the Laffer Curve.

    • The problem is that this may work if you cut taxes from 95% to 90%. But when you cut income tax from 25% to 23% it doesn’t make any difference.
    • Some people want a target income of say £20,000. Thus if taxes fall they can earn the same by working less. Empirical evidence suggests there is little if any supply-side incentive for cutting US or UK tax rates.

    5. Trade Wars - Retaliation is Best
    • The instinctive reaction of politicians is that if one country places a tariff barrier on our exports, we should respond by doing the same. However economic theory suggests that placing a tariff barrier on imports leads to a loss of economic welfare. It is better to not retaliate.
    • Retaliation may help one small domestic industry, but it causes costs to all consumers in the form of higher prices. There is a net welfare loss, that is not recovered by some domestic industries gaining benefit.

    6. Tax Cuts will boost the Economy

    • Another justification given for cutting income tax is that it will increase aggregate demand and hence increase economic growth. However this is not always true because:
    • If you cut income tax for high-income earners, they are likely to save a high % of their extra disposable income. Their marginal propensity to consume is low.
    • If you cut income tax the government has to either cut government spending or borrow. If the government has to borrow from the private sector then they will have less income to spend causing a decline in private sector spending. This is called crowding out. 
    • (Although there are certain times when a government deficit can boost AD - like in a recession.)
    7. Luddite fallacy - automation

    This is the argument that new technology causes job losses. In the nineteenth century, it referred to workers who smashed new spinning machines - fearing jobs would be lost. We now look back and think they are mistaken. But, at the same time, we fear the modern equivalent of new technology (automation) will lead to job losses. But, the principle is the same. If a new technology does cause some jobs to become redundant - new types of jobs will be created. See: The Luddite Fallacy


    Monday, May 7, 2018

    Problems with the Euro

    The Euro is a bold experiment to create the largest currency area in the World. However, the current Euro crisis have revealed deep flaws in the structure of the single currency

    The Euro involves:
    1. A single currency within the Eurozone area.
    2. A common monetary policy. Interest Rates are set by the ECB for the whole Eurozone area.
    3. Growth and Stability Pact. In theory there are limits on government borrowing, national debt and fiscal policy. However, in practice member countries have often violated the strict limits on government borrowing.

    Problems and costs of the Euro

    • Interest rates not suitable for whole Eurozone. A common monetary policy involves a common interest rate for the whole eurozone area. However, the interest rate set by the ECB may be inappropriate for regions which are growing much faster or much slower than the Eurozone average. For example, in 2011, the ECB increased interest rates because of fears of inflation in Germany. However, in 2011, southern Eurozone members were heading for recession due to austerity packages. The higher interest rates set by the ECB were unsuitable for countries such as Portugal, Greece and Italy.

    • The Euro is not an optimal currency area. If a state in the US, such as New York ,was in recession, workers in New York could move to New England and get a job. However, in the Eurozone this is much more difficult; it involves moving country and possibly learning a new language. There are more barriers to the movement of labour and capital within a diverse region like Europe. Therefore, an unemployed Greek can't easily relocate to Germany. see: Two Speed Europe

    • Limits Fiscal Policy. With a common monetary policy it is important to have similar levels of national debt, otherwise countries may struggle to attract enough buyers of national debt. This is a growing problem for many Mediterranean countries like Italy, Greece and Spain who have large national debts and rising bond yields.

    • Lack of Incentives. It is argued that being a member of the Euro protects a country from a currency crisis. Therefore, there is less incentive for countries to implement structural reform and fiscal responsibility. For example, in good years Greece was able to benefit from very low bond yields on its debt because people felt Greek debt would be secured by rest of Europe. But, this wasn't the case, and Greece were lulled into a fall sense of security.

    • No scope for devaluation. Since the start of the Euro, several countries have experienced rising labour costs. This has made their exports uncompetitive. Usually, their currency would devalue to restore competitiveness. However, in the Euro, you can't devalue and you are stuck with uncompetitive exports. This has led to record current account deficits, a fall in exports and low growth. This has particularly been a problem for countries like Portugal, Italy and Greece.


    This shows the effects of Eurozone members becoming uncompetitive. Very high current account deficits.
    • No Lender of Last Resort. The ECB is unwilling to buy government bonds if there is a temporary liquidity shortage. This makes markets more nervous about holding debt from eurozone economies and precipitates fiscal crisis. See: Problems of Italy - why Italian bonds increased despite having a much lower budget deficit than UK.
    • However it is worth noting that since Mario Draghi took over and promised to 'do whatever it takes, the ECB has effectively acted as lender of last resort.

    Italy bond yields rose despite a primary budget surplus

    UK, EU, US unemployment

    Eurozone members have seen a rise in unemployment - higher than US and UK

    • Divergence in bank rates. In theory, the Eurzone creates a common interest rate. However, in the credit crisis of 2010-13, we see rising bank rates for peripheral Eurozone countries, like Italy and Spain. Small and medium sized firms faced higher borrowing costs than in 2005, even though the ECB cut the main base rate. This suggests that the ECB was unable to loosen monetary policy when needed. See more on credit policy 
    • Asymmetric Shocks. If one country experienced an external shock it might need a different response. But this is not possible with a common currency. E.g. German reunification required higher interest rates in order to help reduce inflation but this was not good for many other countries.
    • An oil shock would affect net importers like France more than Norway and the UK who export a lot. Monetary Policy will have different effects in different countries. For example, the UK is sensitive to changes in the interest rate because many people have mortgages.

    Experience of EU Fiscal Crisis

    The great recession of 2008-11 showed the vulnerability of Euro member countries to a common monetary policy. Because they can't devalue and also ask the Central Bank to buy government securities they are at much greater risk of a liquidity crisis.

    Because of fears over liquidity crisis, bond yields rose from Ireland, Spain, Portugal and Greece. As a result these eurozone countries were forced into pursuing spending cuts, and accepting higher interest rates. But, this led to a vicious cycle of lower growth and lower tax revenues.

    See: Why UK bond yields stayed low compared to Euro members

    Problems for UK Economy

    UK economy has additional problems which make joining the Euro a bad idea.
    • Housing market. Many in the UK have a mortgage which is a big % of their disposable income. This is related to the high cost of buying houses in the UK.
    • Variable Mortgages In the UK more homeowners have variable mortgages. These two factors means UK consumers are very sensitive to changes in the base rate. If the ECB kept interest rates higher than the UK needed it would create serious problems in the UK. Arguably to join the UK would need to reform its housing market and reliance on variable mortgages.
    Related Posts on the Euro

    Tuesday, April 3, 2018

    Predictions for the Dollar as the Reserve Currency

    Governments hold foreign currency reserves to help deal with issues such as depreciation in their currency. At the moment, the world’s biggest foreign currency reserve is the US dollar; about 64% of the World’s foreign currency reserves are currently denominated in dollars. This is because, historically, the US economy has been the most secure and powerful economy. However, with the continual decline in the dollar, many countries are fearing that the dollar is no longer the best currency to use and increasingly countries are switching to other currencies such as the Euro.

    Pricing of Commodities in Dollars

    A separate, but related issue, is that most commodities, e.g. oil prices, are also priced in dollars. Oil prices are denominated in dollars because currently, the dollar is the most common currency. If the dollar was to be replaced by the Euro as the world’s currency reserve; it is more than likely that we would see commodities priced in Euro’s. In fact, some countries are already starting to use the Euro rather than the dollar

    Will the Euro Replace the Dollar as the World’s Reserve Currency?

    • Since 1999, the Dollar’s share of the world’s currency reserves have fallen from 70.9% to 64%
    • In the same period, the Euro has increased from 17.9% to 25.8%
    • (the 3rd biggest reserve currency is the Pound sterling 4%
    • (the 4th biggest reserve currency is the Japanese Yen 2.8%)

    Why the Euro May soon Replace the Dollar

    • The Dollar has been very weak in the past 8 years. Against the Euro, the Dollar has fallen by over 30% since 2001. The Dollar has also fallen against the Yen and other currencies. This means that countries holding reserves in dollars are seeing a decline in their value. For example, China has over $1,400 billion of dollar reserves. A 20% devaluation represents a significant loss for them. Therefore, the rational step is to diversify out of the dollar.
    • Countries dropping the Dollar Peg. Many middle eastern Countries such as Saudi Arabia, Kuwait and Syria used to maintain a dollar peg. However, there are signs that they no longer want to keep a peg against a devaluing dollar. Kuwait and Syria have dropped their peg and Saudi Arabia recently decided not to follow the US in cutting interest rates.
    • Dollar’s weakness may continue. The US economy is continuing to slow down as it remains hard hit by the housing slump. US interest rates have fallen and may continue to fall by more than the Eurozone. As interest rates in the US are low it becomes less attractive to buy US dollars so the devaluation will continue.
    • US Trade Deficit (current account deficit of 5%). In recent years, the US has built up a large current account deficit. This has caused an outflow of currency and is a factor in maintaining the weakness of the dollar. (although the recent devaluation though has helped reduce the deficit from over 6% to 4.7%)
    • The Euro is a real alternative. The Euro economy is now as large as the US. The Euro may also be seen as more politically desirable. European countries were less willing to get involved in Iraq and many accuse the US of an ‘imperial overreach’ with too many foreign bases and interference around the world. The European Union, by contrast, provides greater diversity and is politically more attractive, especially to middle eastern countries.
    • Better inflation performance of the Eurozone to the US. There was a marked contrast in response to the recent credit crisis. The US slashed rates to 2.25%, the ECB barely cut rates at all. The lower rates and devaluation of the dollar makes future inflation in the US more likely, this will only make the US less attractive.
    Changing the world’s reserve currency is something that doesn’t happen very often. The US has enjoyed a hegemony really since the end of the First World War. However, that is no reason to suggest that the dollar’s influence will continue. Sooner or later, economic fundamentals are likely to cause people to shift out of the dollar and into alternatives. I will look at the consequences of this potential change in future essays.


    Wednesday, November 1, 2017

    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.


    Saturday, October 21, 2017

    Wednesday, October 11, 2017

    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.

    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.

    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:

    Thursday, October 5, 2017

    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

    Saturday, June 17, 2017

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

    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.
    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

    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.

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