How Will the Financial Crisis End?

The financial crisis which erupted in 2007 caused a very deep balance sheet recession. It's effects are still leaving a dark cloud over the global economy. There are real concerns over

• Persistently high levels of unemployment
• Sovereign default in the Eurozone
• A double dip recession

After the initial stimulus attempts of 2008 and 2009, policy makers have fallen back on short term fiscal austerity as they worry primarily over budget deficits. Yet, this is likely to prolong the economic recession.

What is Happening at the Moment

• Fiscal Austerity
• Limited Monetary stimulus (some in UK and US; the EU's contribution is to increase interest rates in 2011)
• Economic slowdown is spreading to emerging markets such as China.
• Deflationary pressures. The boom in commodity prices is coming to an end. When commodity prices stop rising, it will be more obvious that underlying inflationary pressures are very weak. Some countries will see a fall in prices due to the fall in demand throughout the economy. This deflation will exacerbate slowdown. (deflation)
• Debt Deleveraging. Due to weak growth, falling real wages and prospects of deflation, the real value of debt is increasing. This is making the balance sheet recession worse and limiting spending and investment.
• Falling asset prices. House prices have fallen significantly since boom levels of 2006-07. (UK house prices have been protected by a chronic shortage of supply). But, overall global house prices have fallen due to the financial crisis.

How Will it End?

• Very slowly banks will improve their balance sheets and slowly begin to lend more.
• Slowly consumers will be able to reduce their level of debts and in the future will be more willing to spend.
• Even with a few years of economic growth around 2%, it will take several years for the output gap to close.

This policy of deflation will gradually restore competitiveness. Eventually there will be strong economic growth, but it could take several years.

No Quick End

There will be no quick end to high unemployment and sluggish economic growth.

If policy makers were bold and imaginative, they could have been doing much more to stimulate the economy. They should have avoided the rush to short term austerity. But, I can't see European or US governments simultaneously agreeing on a short term fiscal stimulus package, whilst agreeing on real long term fiscal cuts to entitlement spending.

Europe is even more beleaguered as the unfortunate ECB seem unwilling to diagnose the fundamental problem - which is not just sovereign debt but a slide into a double dip recession which will exacerbate everyone's debt.

Could It Get Worse?

If Europe really messes up and countries other than Greece slip into default, there is potential for crisis to worse. If it led to ever greater rounds of fiscal austerity, a small double dip recession could become a full scale depression. It is possible. It is hard to forecast at this stage. There is a lot of hope, that gradually things will improve.

Examples of Balance Sheet Recessions

1. Japan - the lost decade

Japan Financial Crisis 1990-2001

Latvian Economy

source: Krugman (bully for baltics)

A Kind of Recovery, but unemployment remains high, and GDP well below pre-crisis levels.

Balance Sheet Recession

A balance sheet recession occurs when the private sector is focused on paying down debt and unwilling to borrow and spend (despite zero interest rates). This reluctance to spend and invest causes a sustained weakness in aggregate demand and lower growth.

In a balance sheet recession the banking sector is unwilling to lend because it needs to improve its balance sheet and increase bank reserves.

A balance sheet recession also usually involves falling asset prices and deflationary pressures.

For example, in 1991, the UK experienced a recession caused by a demand side shock (high interest rates and strong pound). When interest rates were cut and the pound devalued, the economy was able to recover. However, in a balance sheet recession, the problem is more fundamental than a temporary demand side shock. This explains why when interest rates were cut in 2008, it failed to solve the recession - because firms, banks and consumers were trying to reduce exposure to debt and increase saving.

Other Features of Balance Sheet Recessions

• Liquidity trap - zero interest rates fail to boost spending or investment because firms and consumers can't afford to borrow more despite the lower interest rates. (liquidity trap)
• Falling Asset prices - The reluctance to borrow means demand for mortgages and houses will fall. This leads to a sustained fall in asset prices. Falling asset prices tend to exacerbate bank losses, making banks even more reluctant to lend.

Graph showing the extent of how much house prices in the US have fallen since the start of balance sheet recession. Source: Economists view

• Deflationary Pressure. The combination of falling asset prices and a stagnant economy can lead to disinflation or actual deflation. Deflation increases the real value of debt and increases the pressure on firms to pay down debt rather than invest or spend.
• Higher saving rates.

Before the recession, saving rates fell to very low levels as borrowing increased. Following the start of the recession, saving rates increased in countries like Ireland, UK and US as consumers tried to pay off debts and increase savings.

• Low Bond Yields. Typically, higher government borrowing leads to higher interest rates (markets fear default). However, in a balance sheet recession, there is high demand for government bonds (because the private sector are risk averse and want to increase savings. Government bonds are seen as one of most relatively secure.

E.g. Japan had government sector debt of over 220% of GDP, yet bond yields were as low as 1%.

In 2011, The US has seen a fall in bond yields to 1.75% on 10 year treasury bonds, despite a rise in government borrowing.

Problems of Balance Sheet Recession

• Conventional monetary policy is insufficient to boost demand. Lower interest rates not enough to encourage spending and investment.
• Fall in private sector spending, creates shortage of demand.
• Negative multiplier effect. Unfortunately, falling asset prices leads to big debts for banks and a greater reluctance to spend.
• Deflation. A deflationary spiral discourages further spending and increases real value of debt.
• They can last a long time. e.g. Lost decade of Japan. Prospect of double dip recession in west and a long period of stagnant incomes, high unemployment and low growth.
• Scope for biflation (both commodity price inflation and deflation of other goods at same time)

Policies to Avoid Recession

Depressingly soon after the great recession of 2009, global economies look to be entering another recession. If we are not technically in a recession, it already feels like it.

Are there any policies which can avoid recession?

David Cameron recently wrote a letter to the leader of the G20 talking about the necessity of improving global economic growth. It was a little vague as to how this economic recovery would occur. He mentions 'tackling key problems' and criticised US and EU for not doing enough to confront the debt overhang to prevent a wider contagion to the wider global economy. Unfortunately, this prognosis offered by Cameron does little to 'restore confidence'. The UK is a good example of how an economic recovery has been sniffed out because the government placed too much importance on short term fiscal austerity at the wrong time. We are not really in a position to preach about the virtues of boosting economic growth.

To imagine the world economy can be fixed by concerted efforts to reduce government spending and reduce government debt is not the case. Yet, politicians seem to have a habit of equating debt with recession as if they are the same thing.

Austerity measures have dampened confidence. They have cause a rise in unemployment and the private sector hasn't taken the place of the government. It may be surprising to some. But, if you depress the population by repeatedly talking about austerity, job cuts and spending cuts, it is almost inevitable.

The UK and US have more options than the Euro members because they don't have the problems of liquidity fears which seem to paralyse Euro bond markets / single monetary policy / floating exchange rate.

It is interesting that the crisis has caused the yield on US treasury bonds to fall to the lowest level since the 1940s. This means investors want to buy US government bonds. It suggests markets fear a recession much more than a US government default

Policies to Avoid Recession

Fiscal Policy

Short Term stimulus / Long Term Structural change.

The government should boost spending. They should take advantage of the low bond yields. This increase in discretionary fiscal stimulus will

• Boost Aggregate Demand
• Create jobs
• Improve business and consumer confidence.

At the same time, the government should set out concrete plan to deal with long term spending commitments. It should make decisions which reduce long term entitlement spending.

• e.g. raise retirement age
• Evaluation of health care spending -
• Caps on cost of health care
• Increase taxes (delayed till after recession)

Here Cameron is right that there needs to be a strong political will to do the right thing. I doubt the US has this political will to agree on either short term stimulus or long term fiscal consolidation.

This combination of long term structural changes will reassure markets about debt. The short term fiscal stimulus will reassure markets, the government is committed to increasing GDP.

Governments need to understand economic growth is a KEY factor in reducing debt/ GDP ratios. You will never get to grips with a debt crisis if you plunge your economy into a recession.


Monetary Stimulus.

Federal Reserve's Operation Twist. This is a move in the right direction. Buying long dated mortgage bonds, helps to keep mortgage interest rates low and can help boost spending / investment. Markets fear it is too little too late. The Federal Reserve may need more quantitative easing to provide monetary stimulus.

Quantitative Easing. Creating money electronically and buying long term securities can have a role in increasing money supply and economic growth.

Higher Inflation Target Now is not the time to worry about inflation. Headline CPI is misleading because it includes temporary cost push factors. The Monetary authorities should be targeting 'core inflation'. This may in practise mean a CPI rate of over 2%. But, that is not the problem. Otherwise in 2012, we could see a period of deflation which would be disastrous for the economy.

Lower Interest Rates

The ECB should reverse its decision to raise interest rates earlier in the year. Only the ECB would increase interest rates as the world economy was heading into a double dip recession. When will the ECB realise there are worse things than a temporary blip in cost push inflation?
However, an interest rate cut of 0.5% would only have a limited effect in boosting EU growth. Much more is needed, but at least it would be a signal they are interested in boosting growth.

Related

• How To Avoid A Recession
• Can Recessions be avoided?
• Can Tax cuts avoid a recession?
  

How Interest Rate Affects Savers and Borrowers

Readers Question: “how does the current interest rate affect the savers and the borrowers?”

The current Bank of England base rate is at a historical low of 0.5%.

• A low interest rate means savers gain a low return (interest payments) on their savings
• A low interest rate means borrowers will pay a low interest payment on their debt.

Traditionally you would expect this kind of interest rate to discourage saving and encourage borrowers.

Low rate of return for savers. 0.5% is a very low interest rate for savers. With CPI inflation at over 4%, this means there is a negative real interest rate. Therefore, savers are seeing a decline in their living standards.

In theory, this low rate of interest would encourage savers to spend rather than save. However, the continuing recession and threat of unemployment is discouraging spending. But, given the low rates of interest savers have been encouraged to find alternative forms of investment than bank accounts. It is one factor behind the increase in demand for gold.

Despite the ultra low interest rates, saving rates have actually increased. This shows that the interest rate is only one factor that determines saving rates. Saving rates have increased in UK and US because:

• Banks have encouraged saving to improve their balance sheets.
• Banks give a commercial interest rate substantially above the bank of England base rate.
• Confidence. One of the key factors determining saving rates is expectations of the future economic situation. With spending cuts, rising unemployment and fears of a double dip, it is unsurprising there has been a preference for saving rather than spending.
• Change in Attitude. Before the credit crunch, the UK was a nation of borrowers. The saving rate was very low and debt levels high. The financial squeeze has to some extent changed attitudes to saving and debt. (borrowing v austerity)
  

The very low interest rates is a reason why government in the UK and US (outside the Euro) have been able to borrow large amounts at low interest rates.

In theory, this is a good time to be a borrower. Interest rates are very low so interest repayments are a smaller % of income. This makes it easier to meet mortgage repayments. Low interest rates is one reason why home repossessions have been lower compared to the last recession (in 1991 where rates reached double figures)

Related

• Interest rates and the economy

Impact of Tax Cuts on Jobs

Readers Question: Does any evidence exist to support the argument that tax cuts for the wealthy will lead to an increase in jobs here in the U.S., not abroad? Any evidence that "trickle-down" economics is valid? What are the benefits of "supply-side" economics, particularly for the working class, the middle-class if you will?

Cutting taxes can have two effects:

1. Short term boost in demand as people have more income to spend
2. Long term increase in productive capacity as people more willing to work.

Do Tax cuts for the wealthy increase jobs?

Tax cuts can lead to an increase in jobs. For example, the UK has a 50% rate of marginal income tax for those earning over £145,000 a year. At this rate of marginal tax, there is a reasonable degree of disincentive to work. For example, some people may be disinclined to do overtime. There may be a bigger incentive to work abroad. If you cut this 50% tax rate to 40%, it is quite likely, there will be some supply side incentive for greater innovation and investment, which could trickle down to higher growth and lower unemployment. (Economists call for 50% tax rate cut)
However, there is still a lot of uncertainty:

• How much this higher tax rate will raise for HMRC (we will find out at end of tax year)
• How much disincentive this tax rate actually is.

The impact of cutting income tax is not straight forward. There are two effects at work:

• substitution effect - tax cuts make work more attractive - increasing productivity and output.
• income effect - tax cuts mean you can earn a target income by working less. This effect encourages less work.

Also, it depends whether people expect tax cut to be temporary or lead to higher taxes in the future (to balance budget)

Therefore there is no guarantee cutting income tax rates does actually increase productivity.

Which Tax Rate boosts Productivity?

There is also a big difference between cutting a higher income tax rate of 80% and cutting an income tax rate of 30%. Yes, there is a disincentive from higher taxes but clearly a marginal rate of 80% has a much greater disincentive impact than 20 or 30%. Cutting very high tax rates should give a bigger boost to hours worked than low tax rates.

Cutting Taxes for the Wealth?

As Warren Buffet pointed out, the tax on investment income is very low in the US. He says he pays around 17% on his investment income. This is a lower tax rate than other workers in his office who pay closer to 40% in tax. If you cut tax on this investment income, there will be a very minimal trickle down effect. The wealthy just get more from their investments.

Also as Warren Buffet pointed out, when tax rates were 39% in the 1970s, the wealthy didn't leave the US. People didn't stop working. The disincentive effect of higher taxes is often grossly over-exaggerated.

Tax cuts for Wealthy v Poor

Cutting tax on the wealthy may lead to small improvements in productivity and small increase in demand. But, cutting tax on low income earners would have much greater impact on boosting growth and jobs.

A millionaire has a low marginal propensity to consume. If a millionaire gets a tax cut, he may spend some of this extra income, but he is likely to save a high %.

If you cut tax for someone struggling on $15,000 a year, they are likely to spend it all. They don't have the luxury of saving. They have a low marginal propensity to consumer.

Therefore tax cuts for low income earners have a bigger impact on increasing spending and demand in the economy.

Depends on the Tax

When you talk of taxing the wealthy it depends which tax you cut.

• Cutting inheritance tax will have little, if any impact on boosting economic investment and productivity.
• Cutting payroll taxes, will have a much bigger impact on creating incentive to employ workers.

Empirical Evidence

• Some claim the Reagan tax cuts helped create jobs (joint economic committee)
• Some expected tax increases of Clinton administration to create recession and job losses, but they didn't. The Clinton era saw one of fastest eras of job creation and economic output.
• The Tax cuts in US of 2001, led to a very poor job creation.

(Of course many other factors are at work other than just tax cuts)

Further Reading

• Economics of tax cuts
• Analysing the impact of a cut in income tax pdf
• Religion of tax cuts in US
• Advantages of tax cuts