Economics Update 11th December 2012

• Tax avoidance is a hot topic at the moment. A look at which companies avoid the most.

 

• Also, why are we keener to boycott Starbucks than Amazon or Google? Is it because Starbucks in on the high street and online choices we keep to ourselves?

Portugal in Crisis

Readers Question: Can you tell what Portugal has done to reduce the Current Account as % GDP deficit so steeply?

  

The reduction in the Portuguese deficit is quite striking. From what I can gather, essentially, the rapid reduction in the current account is due to a sharp fall in consumer spending on imports, combined with some growth in exports – helped by improvements in unit labour costs. But, the Portuguese economy remains deeply depressed.

 see also: Portugal Economic crisis

EU Competitiveness

 

 In the lead up to the Euro debt crisis, there was a marked divergence in competitiveness within the Eurozone. In fact, some economists suggested that the currency imbalances were the root cause of the Eurozone fiscal crisis.  However, recent evidence suggests some restoration of competitiveness within the Eurozone. See: the extent of EU competitiveness improvements

How Important are Credit Ratings?

Do you remember all those sub-prime mortgage bundles which caused the credit crisis? These mortgage bundles which later proved to be almost worthless were, for a considerable period, given a AAA credit rating by rating agencies. Even Greece, now on the verge of insolvency, maintained an A credit rating until May 2009. ( What did a credit rating of A mean for Greece? It meant the credit rating agencies didn’t really know what was coming quite soon. (nor the rest of the market either)

Because credit ratings are a highly visible signal, they can perhaps gain more political importance than they perhaps deserve. A triple AAA credit rating sounds good. (Plus, it’s much easier to explain to the public than the ‘merits of expansionary fiscal policy in a liquidity trap’.)

- more on should we worry about losing our AAA credit rating?

The Decline of the Coal Industry

 

An essay looking at the long decline of the UK coal industry.

Graph of the Week

 

Triple dip recession in UK likely. OBR budget deficit forecasts make grim reading too.

Reasons for US Budget Deficit

 

 A look at why the US deficit is so large. Spot the recession.

Quick Links

•  How valuable is the Oxbridge interview process?
•  In 16 developed economies, labour took a 75% share of national income in the mid-1970s, but this has dropped to 65% in 2007. Why wages are declining as a share of national income - and what it means. 

Who Does the Government borrow from?

Who does the Government borrow from?

If government spending is greater than tax revenues, they need to make up the shortfall by borrowing from the private sector. To borrow, the government will sell bonds / gilts.

These Government bonds or gilts are bought by a variety of financial institutions, including:

• Pension funds
• Investment trusts
• Individuals
• Local councils
• Banks and building societies.

Some of these bonds may be bought by overseas investors, but about 70-75% of UK government debt is held by UK citizens of UK financial institutions.

Graph Showing who the UK government is Borrowing from

• This shows that in the period 2007-2012, the percentage UK gilts held by insurance and pension funds has fallen from 50% to 22%. There has been a sharp rise in gilts held by the Bank of England.
• The percentage of UK gilts held by overseas holdings has held fairly constant at 30% 

More detail on who government borrows from

(How to find) Selecting ‘United Kingdom Economic Accounts, Q2 2012 (Pdf 845Kb)’ , see page 182, Table X16, (government securities F.33211), explains NBMX NBTF NBZN NCMD NCYT NERD NEXL NGCZ from. PSF Finance stats at HM Treasury

How the UK government Borrows Money

• The Bank of England used to be responsible for selling UK government debt. But, now that responsibility is undertaken by the Debt Management Office (The DMO is part of the UK Treasury)
• Nearly every week the DMO is having a gilt auction, where they sell gilts and bonds
• The Debt Management Office sell a range of financial securities. These are basically loans or IOUs. These bonds have a fixed interest payment. e.g. a £1,000 bond may have an interest payment of £50, giving an interest rate of 5%.
• The most common type of debt is a long dated gilt. These have a maturity of say 30 years. They are often bought by pension funds and investment trusts looking for a guaranteed return over a long time. These pension funds are typically UK based funds, but, also include foreign buyers.
• Foreign buyers are often more attracted by short term gilts which reach maturity in a short time - 3 months, 1 year e.t.c.

UK debt held by Oversees investors

• In the UK about 25-30% of government debt is held by foreigners. (see: UK debt held by foreigners)
• This % can vary between different countries. For example, in Italy, the % of debt held by foreigners is over 60%. In Japan only 5% of national debt is held by foreigners.
• In the US, about 32% of total US debt is held by foreigners. The biggest foreign holder of US debt is China, Japan and UK.

Central Bank and Bond Holdings

Usually government borrowing is financed by selling bonds to the private sector. But, in some circumstances, bonds can be bought by Central Banks. For example, in the UK, the Bank of England pursued quantitative easing. This involved creating money electronically, and using this to buy government bonds. Therefore, in 2011, the Bank held a substantial % of UK government debt.

However, the bank are committed to selling these bonds when the economy recovers and they end quantitative easing. (see: amount of bond purchases at Bank of England).

In the Eurozone, the ECB is not willing to act as this lender of last resort.

How Easy is it for the government to borrow?

In some cases, some governments seem to be able to borrow very large amounts. In the 1950s, UK national debt was over 200% of GDP. In 2012, Japanese national debt has increased to over 229% yet markets are still willing to lend the government money (Who Japan borrows from). However, in the Eurozone, governments have found difficulty borrowing - even though debt levels are much lower. In some Eurozone economies, such as Greece and Ireland, governments have been forced to seek bailouts by institutions, such as the ECB and IMF.

Factors Which Make it Easier for the Government to Borrow

• Low interest rates mean the interest rate on government bonds is relatively low. This means the cost of servicing debt is relatively low. If interest rates rose, the cost of servicing national debt could in itself increase the borrowing requirement.
• Recession makes commercial bonds unattractive, therefore, investors are keener to go for the perceived security of government bonds.
• A policy of quantitative easing - when the Central Bank buys a range of bonds this increases the demand for government bonds and this increased demand makes it more attractive to buy bonds in an auction.
• The UK's fiscal position, although bad, is comparatively not as bad as many competitors, therefore there is still foreign demand for government bonds - despite threats of rating downgrades.

What Could make selling debt more difficult in Future?

• If the economy didn't recover leading to a worse fiscal position than expected.
• More bank losses which government need to absorb.
• An end in quantitative easing would reduce demand for bonds
• Rising interest rates would make it more expensive to buy.
• Threat of inflation and devaluation of pound would make foreign investors want to leave UK

Related

• National debt from a historical perspective
• Government borrowing in recessions
• UK National Debt

Deflation vs Inflation

Source: US Bureau of Labor statistics (showing deflation in early 1920s and 1930s)

In the MPC's last monthly inflation report they forecast that inflation could fall to 1%. They even hinted at the possibility of deflation. What is deflation and why does it strike fear into economists and policy makers?

Deflation is simply a fall in the general price level. If this deflation a result of improved productivity and greater efficiency, it could be benign. But, usually deflation is caused by falling demand and lower growth. It is no coincidence that our worst period of deflation was in the great depression of the 1930s. This kind of deflation is very damaging because:

1. Lower Spending. When prices are falling, there is an incentive to delay purchases. Why buy a TV now, when it will be cheaper in 12 months? Look at how the housing market is suffering because of falling prices. Nobody wants to buy with falling house prices; this is why property transactions have slumped and of course causes further falls in prices. In Japan, the decade of deflation created a culture of thrift and saving. Japanese housewives just wouldn't spend. Tax cuts, government spending and interest rate cuts all failed to stimulate growth because all the Japanese wanted to do was save (an example, of the Paradox of thrift)
2. Liquidity Trap. A liquidity trap occurs when lower interest rates fail to stimulate spending. If prices are falling by 2%, it can be more attractive to save money in cash then spend. Therefore, cutting interest rates to 0% may be ineffective in increasing demand.
3. Increasing Burden of Debt. If you take out a mortgage and make mortgage payments of say £500 a month, inflation will progressively reduce the real value of your mortgage interest payments. High inflation thus makes a mortgage more attractive, over time, it increases the disposable income of mortgage owners.

• However, with deflation, this £500 a month becomes a bigger % of your disposable income. In deflation, debt becomes an increasing burden reducing spending and economic growth.

• The problem is that the UK and US are increasingly indebted, personal savings are very low. Personal debt is very high therefore, deflation would be very damaging for an economy burdened with a legacy of debt.
• 4. Rising Real Wages. Workers will general seek to prevent a cut in nominal wages. Therefore, with deflation, real wages rise by stealth. This can lead to real wage unemployment. With deflation, it is much more difficult for prices and wages to adjust.

How To Overcome Deflation.

Basically, Monetary authorities need to implement bold policies. In particular they need to increase inflationary expectations. The problem is Central banks are so used to trying to reduce inflationary expectations, that they can struggle to implement the opposite. However, the experience of Japan in the 1990s and 2000s suggests timid policies can lead to several years of economic stagnation.

• Costs of Inflation
• What is more likely inflation or deflation?
• Questions on deflation

Causes of European Unemployment

Up until the 1970s, the European Union had very low rates of unemployment. It was even referred to as the 'European unemployment miracle' But, after the supply side shocks of the 1970s, unemployment rose and remained stubbornly high until the mid 1990s. There was a slight drop in unemployment during the mid 2000s. But, since the current recession (08-12) unemployment has risen to over 10% - and shows no signs of falling. In some parts of southern Europe, unemployment has exceeded 20%.

What is the Cause of Unemployment in Europe?

Cyclical Unemployment The sharp rise in unemployment since the start of the recession in 2009 reflects the impact of falling demand on jobs and employment.

In particular, attempts at fiscal consolidation without any monetary stimulus have led to the double dip recession and rising unemployment.   (Europe and fiscal consolidation)

Conservatism of ECB. The ECB has a strong reputation for keeping inflation low. The over-riding target of monetary policy is low inflation and arguably this holy grail of low inflation means they are willing to sacrifice growth and investment (e.g. decision to increase interest rates in 2011 because of fears over inflation). It explains the contrast in response to the ECB and Bank of England to the current recession. (Theodore Peligidis 1998 link)

Overvalued Exchange Rate. Some countries in southern Europe, such as Greece, Portugal and Spain have experienced falling competitiveness within the Eurozone. In a single currency, they have been unable to devalue and this has made exports less competitive - leading to lower export demand.

Rigidities in the Euro. The Euro prevents individual countries - cutting interest rates, pursuing quantitative easing and  devaluing currency to improve competitiveness. Another problem is the new fiscal stability pact which places limits on fiscal policy. This gives Eurozone economies few options to pursue higher economic growth.

Supply Side Factors

High Unemployment Benefits. European states tend to have generous welfare benefits which decrease incentive to get a job. However, countries like the Netherlands have seen low unemployment rates despite similar benefit rates.

Labour Market Rigidities. European economies often have generous protection for workers. e.g. hard to hire and fire workers, maximum working week. Protection for trades unions. This gives protection for 'insiders' but not outsiders. It also could explain why European unemployment could be for a longer duration. Within the political systems there is often reluctance to reform labour market policies which protect certain workers at the expense of the unemployed. (Bean 1994)

Skills Based Changes. Factors such as globalisation and increased specialisation have led to rapid changes in demand for skilled workers. The consequence is that unskilled workers have found it more difficult to gain employment. (Lawrence 1994, Krugman 1995, Baldwin and Cain 1997)

Hysteresis. Long term unemployment can make it more difficult for people to find work. Long-term unemployment is rising and also encouraging people to give up and leave the labour force. When we look at inactivity rates, the employment situation looks even worse.

Unemployment is underestimated in the US. US unemployment rates are lower, but arguably there is a higher disguised rate of unemployment including low paid part time jobs.

Conclusion

The more you look into European unemployment the more you realise there is no simple answer. It is unsatisfactory to explain it all away with blaming labour market rigidities and generous welfare benefits. O.J.Blancard (2004) states "High social protection is not inconsistent with low unemployment. However, it must be provided efficiently."
It is also important to consider both demand and supply side policies. The scale of the current EU recession illustrate how the ECB's conservatism in Monetary policy could adversely affect unemployment in both the short term and longer term.
Further Reading

• Causes of Unemployment
• European Unemployment stats

External Links

• Explaining European unemployment
• European Unemployment - myths and realities

Unemployment in the UK 2012

 

UK Unemployment since 1979.

See updated post on UK Unemployment

Brief History of Unemployment in UK

UK unemployment 1881-2015. Source: ONS historical unemployment + ONS

After the ravages of the Great Depression era where unemployment was over 22%, unemployment in the UK remained relatively low from 1945 until the late 1970s. When Beveridge introduced the Welfare State in 1945, one thing he mentioned was the necessity of maintaining full employment. Using demand management policies and benefiting from a boom in global trade, the UK more or less achieved full employment, until the 1970s. In the 1970s, rising oil prices caused stagflation and unemployment began to rise but was still relatively low.

It was in the manufacturing recession of 1980-81 when unemployment rose to unprecedented levels. Not only did unemployment reach 3 million, but, it remained stubbornly high until 1986 well into the economic recovery. The huge rise in unemployment was due to the strong value of the Pound, high interest rates and the deflationary impact of strict monetarist policies. In particular, it was the manufacturing sector that suffered. Male full time, unskilled labour was particularly affected.

Unemployment remained high throughout the 1980s. Even at the peak of the boom in 1989, 1.6 million people were unemployed. This figure involved high rates of structural unemployment (also known as the natural rate of unemployment). This structural unemployment was because the recession of 1981 had made many unskilled workers unemployed. In the fast changing workplace, these former coal miners and ship builders struggled to get work in the new economy. Geographical unemployment was also a strong feature of the 1980s. Former areas of manufacturing and mining, struggled to cope with the large scale redundancies.

In 1991, unemployment rose again, as the economy slipped into another recession. Unemployment peaked in 1993 at just under 3 million. Unlike the 1980s, unemployment fell quicker. From the mid 1990s to 2008, UK unemployment was relatively low. Looking at official statistics, unemployment was fairly close to full employment at just over 3%.

Low unemployment was due to:

• Long period of economic growth
• Disguised unemployment, many unemployed were allowed to take sickness and disability benefits. Therefore, they are not counted as unemployed. See also: What is True Level of Unemployment?
• The Labour Force survey has consistently been higher than the government record of people on Job seekers allowance. This reflects the fact it is very difficult to get benefits these days. Some unemployed are not eligible for benefits for a variety of reasons.

• Regional Recovery. Former depressed areas like South Wales and the North East have been relatively successful in finding new industries to replace the old heavy manufacturing.
• New Deal. Better education and training for the unemployed to get back to work.

This shows that unemployment is highly cyclical. When the economy goes into recession, unemployment typically has increased to 3 million. 

Unemployment during great recession.

Unemployment rose in the great depression, but was still lower than in previous recessions. For more on unemployment in this period see: the UK unemployment mystery.

Other essays:

• Is Unemployment a price worth paying for low inflation?
• Types of Unemployment

Factors that determine international competitiveness

A look at factors affecting international competitiveness. International competitiveness is a measure of the relative cost of goods/services from a country. Countries which can produce the same quality of goods at a lower cost are said to be more competitive.

1. Relative Inflation

If the inflation rate is relatively lower than in other countries, then over time you become more competitive because your goods will be increasing at a slower rate. For example, in the post-war period, Japan and Germany had relatively lower inflation rates than major competitors, this helped them to become more competitive.

 

This graph of relative inflation rates showed that during the period shown, inflation in Greece fell from close to 5% to below 2%. This suggests that Greece will have become slightly more competitive in this period.

2. Productivity

Productivity is a measure of output per input. The most common measure would be labour productivity. For example, with improved technology and education, a country can enjoy higher labour productivity and therefore produce goods at a lower cost. Higher labour productivity is the key to increasing competitiveness and living standards at the same time.

 

German vs Italian labour productivity. During this period, Italian labour productivity growth has tended to lag behind Germany, leading to lower competitiveness of Italian exports.

This shows labour productivity index for the UK and Germany. Between 1990 and 2005, Germany labour productivity increased 25 base points. UK labour productivity increased by 35 base points. Showing that the UK had faster improvements in labour productivity during this period.

3. Exchange Rate

Movements in the exchange rate will determine competitiveness. For example, a sharp depreciation will make exports cheaper and more competitive. An increase (appreciation) in the exchange rate, makes the foreign currency price more expensive.

Often movements in the exchange rate reflect relative costs. For example, if a country has lower inflation, this will lead to an appreciation in the exchange rate, making exports relatively more expensive. Thus a floating exchange rate helps to maintain relative competitiveness levels.

However, sometimes economies can artificially maintain a lower value of the exchange rate to maintain competitiveness. For example, China has been accused of exchange rate manipulation. China buys large quantities of US securities, this causes an increase in the value of the dollar and helps to keep the Yuan undervalued. Therefore, this helps Chinese exports to be more competitive and explains the large Chinese current account surplus

Government has used supply-side policies to increase productivity. E.g. education and training.
However, there is a limit to what the government can do to increase productivity. Increased productivity can be due to other factors.

Competitiveness in the Euro

In the Euro, countries have a permanently fixed exchange rate - they cannot devalue to restore competitiveness. Therefore divergences in labour costs and productivity will have a bigger impact on competitiveness than in a floating exchange rate.
.

Source: Krugman, How overvalued is southern Europe? link

This shows inflation in Spain is higher than Euro area - leading to a decline in Spanish competitiveness.

See: EU Competitiveness

4. Tax Rates

Tax rates on labour and corporations will be a factor in determining competitiveness. For example, higher labour taxes will increase the unit cost of labour faced by firms, leading to lower competitiveness.

5. Cost of Doing Business

It is argued that countries with more labour market regulations, and regulations about doing business will have higher costs and lower competitiveness. For example, the difficulty in gaining planning regulations to expand a factory.

The World Bank produces a list of countries which are the 'easiest places to do business'. The criteria include factors such as flexibility of labour markets, degree of regulations, protection of private property.

 Top 10 ease of doing business

1. Singapore
2.  Hong Kong
3.  New Zealand
4. United States
5.  Denmark
6.  Norway
7.  United Kingdom
8.  South Korea
9.  Iceland
10.  Ireland

6. Infrastructure

A key factor in determining competitiveness is the cost of transport. For example, some argue the UK's competitiveness is undermined by bottlenecks in transport, such as limited airport capacity in London and traffic jams on major roads.

7. Tariffs and non-tariff barriers

A key factor is the cost of tariffs and non-tariff barriers. For example, after the UK leaves the Single market, if it has regulatory divergence, then British business may have higher costs as a result of differing standards.

Related

• Government policies to increase competitiveness
• International Competitiveness

Does a Current Account Deficit Matter?

A current account deficit measures the balance of trade in:

• Goods
• Services
• Net investment incomes and transfers

A deficit on the current account means a country is importing more than we are exporting. This will have to be matched by a surplus on the financial and / or capital account.

The financial account comprises of two main features:

• Short Term Capital flows e.g. hot money flows and purchase of securities
• Long Term Capital flows e.g. investment in building new factories

A deficit on the current account will be matched by a surplus on the financial/capital account

Some economists argue we need not worry about a current account deficit. This is because:

1. If a current account deficit is financed from long term capital inflows then this can be beneficial for the economy. Inward investment can increase the productive capacity of the economy.
2. In an era of globalisation it is much easier to attract sufficient capital flows to finance the deficit.
3. If the deficit gets too large it will cause a devaluation which helps to reduce the deficit. Also when there is a slowdown in consumer spending the deficit will fall.
4. A current account deficit provides an outlet for domestic demand and prevents inflation.

Reasons to Worry about a Current Account Deficit

1. There could be problems financing the deficit in the long term. A short term deficit is not a problem, but if you have a deficit of over 6% of GDP, then it is a problem if you rely on Capital flows. A significant part of the current account deficit in US is financed by Chinese investors buying US securities, at relatively low interest rates.
2. Most countries would not be able to borrow such large amounts at low interest rates. The US currently can because the US is seen as the World’s reserve currency. However if attitudes to the US economy change and investors lose their confidence in the US economy, they will stop buying US debt. This will cause two problems.

• US interest rates will need to rise to attract enough people to buy the debt. These higher interest rates will reduce demand in the economy. Higher interest rates will particularly hurt American consumers who have large amounts of debt at the moment.
• If capital flows can’t be attracted, then the dollar will continue to devalue further. This could cause inflationary pressures, interest rates may need to rise to stabilise the dollar.

Basically to correct the deficit would be a painful experience for the US economy and result in a slowdown or possibly recession

3. In the US the current account deficit is to a large extent caused by excess spending in the economy. It is partly caused by government borrowing which increases Aggregate Demand in the economy and hence growing demand for imports. A large current account deficit is often a sign of an unbalanced economy. It could be a sign of structural weakness and an uncompetitive manufacturing sector. This is particularly a problem in the Eurozone where the exchange rates are permanently fixed.

4. A deficit on the current account increases foreign liabilities. In the beginning, a current account deficit could be just a deficit on buying goods. However, over time, the deficit will be increased by the interest payments on the capital surplus. Foreigners invest in the US. On these investments, they receive interest payments or dividends. These dividends count as a debit on the current account. Therefore the longer the deficit goes on the higher the level of investment income debits will be accrued. This means that in the future the economy will need to attract capital flows just to pay off the investment income. As well as the deficit on goods and services.

 

US current account deficit reached 6% of GDP in 2006. This reflected strong domestic demand and a decline in competitiveness. The credit crunch caused a reduction in US current account deficit.

Example of Iceland's Current Account Deficit

Iceland is an example of a country with a large current deficit which later imploded.
In the years leading up to 2008, there was a sharp inflow of capital to Icelandic banks. This enabled Iceland to run a record current account deficit. Iceland was spending more than they were earning. When capital flows dried up, banks lost money and there was a rapid deterioration in the current account.

Current Account Deficits in the Eurozone

In the Eurozone, current account deficits are a bigger cause for concern because countries have a permanently fixed exchange rate (common currency). Therefore they can't devalue to restore competitiveness. Therefore countries may have to pursue internal devaluation (deflation) to restore competitiveness.

Conclusion

It depends on the size of the current account as a % of GDP. Clearly in Iceland's case, over 20% of GDP was unsustainable. But, in US case 6% of GDP later shrank to a more manageable 3% of GDP.
A current account deficit is often a signal of another underlying problem. For example, a banking boom (in Iceland's case). A boom in domestic demand or a lack of competitiveness in Eurozone.

See also:

• Factors affecting current account deficit
• Solving UK Current account deficit
• Economic growth and current account

External links

• Do Current Account deficits matter?
• Do Current Account deficits matter? Axel Merk, May 23rd 2006

Causes of Great Depression

The Great Depression was a period of unprecedented decline in economic activity. It is generally agreed to have occurred between 1929 and 1939. Although parts of the economy had begun to recover by 1936, high unemployment persisted until the Second World War.

Background To Great Depression:

• The 1920s witnessed an economic boom in the US (typified by Ford Motor cars, which made a car within the grasp of ordinary workers for the first time). Industrial output expanded very rapidly. 
• Sales were often promoted through buying on credit. However, by early 1929, the steam had gone out of the economy and output was beginning to fall.
• The stock market had boomed to record levels. Price to earning ratios were above historical averages.
• The US Agricultural sector had been in recession for many more years
• The UK economy had been experiencing deflation and high unemployment for much of the 1920s. This was mainly due to the cost of the first world war and attempting to rejoin the Gold standard at a pre-world war 1 rate. This meant Sterling was overvalued causing lower exports and slower growth. The US tried to help the UK stay in the gold standard. That meant inflating the US economy, which contributed to the credit boom of the 1920s.

Causes of Great Depression

1. Stock Market Crash of October 1929

During September and October, a few firms posted disappointing results causing share prices to fall. On October 28th (Black Monday), the decline in prices turned into a crash has share prices fell 13%. Panic spread throughout the stock exchange as people sought to unload their shares. On Tuesday there was another collapse in prices known as 'Black Tuesday'. Although shares recovered a little in 1930, confidence had evaporated and problems spread to the rest of the financial system. Share prices would fall even more in 1932 as the depression deepened. By 1932, The stock market fell 89% from its September 1929 peak. It was at a level not seen since the nineteenth century.

• Falling share prices caused a collapse in confidence and consumer wealth. Spending fell and the decline in confidence precipitated a desire for savers to withdraw money from their banks.

2. Bank Failures

In the first 10 months of 1930 alone, 744 US banks went bankrupt and savers lost their savings. In a desperate bid to raise money, they also tried to call in their loans before people had time to repay them. As banks went bankrupt, it only increased the demand for other savers to withdraw money from banks. Long queues of people wanting to withdraw their savings was a common sight. The authorities appeared unable to stop bank runs and the collapse in confidence in the banking system. Many agree, that it was this failure of the banking system which was the most powerful cause of economic depression.

50% fall in bank lending during the Great Depression. Period in grey - recessions.

• Because of the banking crisis, Banks reduced lending, there was a fall in investment. People lost savings and so reduced consumer spending. The impact on economic confidence was disastrous.

Great Depression in US

Over 20% fall in US real GDP

Four consecutive years of negative growth 1929-32.

US unemployment rose from zero in 1929 to over 25% in 1932 - indicating the severity and seriousness of the decline in economic activity.

US Deflation

 Significant fall in US consumer prices.

Great Depression in the UK

The great depression in the UK was less severe because

There had been no boom in the 1920s (it was actually a period of low growth)

After leaving the Gold Standard in 1932, the UK economy recovered relatively well.

The UK also experienced a long period of deflation in the 1920s and 1930s. See: History of inflation

With falling output, prices began to fall. Deflation created additional problems.

• It increased the difficulty of paying off debts taken out during the 1920s.
• Falling prices encouraged people to hoard cash rather than spend (Keynes called this the paradox of thrift)
• Increased real wage unemployment (workers reluctant to accept nominal wage cuts, caused real wages to rise - creating additional unemployment)

Unemployment and Negative Multiplier Effect

As banks went bankrupt, consumer spending and investment fell dramatically. Output fell, unemployment rose causing a negative multiplier effect. In the 1930s, the unemployment received little relief beyond the soup kitchen. Therefore, the unemployed dramatically reduced their spending. See: Negative multiplier effect

Global Downturn

America had lent substantial amounts to Europe and the UK, to help rebuild after first world war. Therefore, there was a strong link between the US economy and the rest of the world. The US downturn soon spread to the rest of the world as America called in loans, Europe couldn't afford to pay back. This global recession was exacerbated by imposing new tariffs such as Smoot-Hawley which restricted trade further.

Different views of the Great Depression

Monetarists View

Monetarists highlight the importance of a fall in the money supply. They point out that between 1929 and 1932, the Federal Reserve allowed the money supply (Measured by M2) to fall by a third. In particular, Monetarists such as Friedman criticise the decisions of the Fed not to save banks going bankrupt. They say that because the money supply fell so much an ordinary recession turned into a major deflationary depression.

Austrian View

The Austrian school of Economists such as Hayek and Ludwig Von Mises place much of the blame on an unsustainable credit boom in the 1920s. In particular, they point to the decision to inflate the US economy to try and help the UK remain on the Gold standard at a rate which was too high. They argue after this unsustainable credit boom a recession became inevitable. The Austrian school doesn't accept the Friedman analysis that falling money supply was the main problem. They argue it was the loss of confidence in the banking system which caused the most damage.

Keynesian View

Keynes emphasised the importance of a fundamental disequilibrium in real output. He saw the Great Depression as evidence that the classical models of economics were flawed.

• Classical economics assumed Real Output would automatically return to equilibrium (full employment levels), but the great depression showed this to be not true.
• Keynes said the problem was lack of aggregate demand. Keynes argued passionately that governments should intervene in the economy to stimulate demand through public works scheme - higher spending and borrowing.
• Keynes heavily criticised the UK government's decision to try balance the budget in 1930 through higher taxes and lower benefits. He said this only worsened the situation.
• Keynes also pointed to the paradox of thrift.

Marxist View

The Marxist View saw the Great Depression as heralding the imminent collapse of global capitalism. With unemployment over 25%, Marxists held that this showed the inherent instability and failure of the capitalist model. Furthermore, they pointed to the Soviet Union as a country which was able to overcome the great depression through state-sponsored economic planning.

How important was the Stock Market Crash of 1929?

The stock market crash of October 1929, was certainly a factor which precipitated events. It did cause a decline in wealth and severely affected confidence. However, changes in share prices were a reflection of the underlying boom and bust in the economy. Also, a collapse in share prices might not have caused the great depression if bank failures had been avoided. In October 1987, share prices fell by even more (22%) than black Monday. But, it didn't cause an economic recession.

Related 

• Essays on Credit Crunch 
• The UK economy in the 1930s 
• Recession of 1930s vs Recession of 2008-10

• Essays on the Great Depression by Ben S. Bernanke at Amazon.com

Austrian Economics Explained

Austrian economics is a school of thought which places great emphasis on free markets, private property and absence of government intervention. Important Austrian economists include Carl Menger, Ludwig Van Mises, and Freidrich Hayek. Modern day supporters include congressman Ron Paul. Austrian economists oppose Keynesian economists on issues related to fiscal policy: see: Austrian debate.

Main beliefs of Austrian School of Economics

1. Laissez-faire economics. Proponents of Austrian school of Economics believe in free markets and avoiding government intervention in markets. They argue government intervention usually creates more problems than it solves. See: laissez-faire economics

2. Recessions caused by credit cycles. They argue Central Banks encourage excessive growth of credit by keeping interest rates too low for too long. Some argue the credit bust of 2008 is a good example of Austrian economics theory in action. Ludwig Van Mises also predicted the depression of 1929. 

3. Austrians criticise Keynesian fiscal policy. They argue government intervention to stimulate demand just leads to wasted resources, greater inefficiency and stores up more problems. I examined these arguments in detail here: - Hayek on Eurozone crisis and criticism 

4. Support the Gold Standard. Austrian economists are critical of the use of fiat money which enables governments to devalue exchange rates and destroy savings through creating inflation. The gold standard means money would only be created if it can be converted into gold.

5. Critical of Central Banks. Austrian economists are critical of Central banks and their ability to create inflation by printing money and the fractional reserve system.

6. Rejection of statistical econometric models. Austrian economics emphasises the importance of logical deduction from people's behaviour and avoiding the use of statistics and empirical models. This sets them apart from related schools like Chicago and is one reason why they are not in the mainstream of economics.

7. Civil Liberty Support of free markets and control of money supply essential for promoting civil liberty and social progress.

Criticism of Austrian Economics

1. The belief in the efficiency of markets is countered by many examples of market failure. E.g. growth of subprime mortgages / securitisation leading up to credit crisis of 2008
2. High Tax and high spending regimes do not necessarily impinge on social freedoms. E.g. Many western European economies have high tax and high government spending. But, citizens get a comprehensive welfare state, education and health care. This compares favourably with US, where health care is expensive and piece meal.
3. Controlling Money Supply is much more difficult in practise than theory suggests.
4. Gold Standard can create severe economic problems such as the deflation and high unemployment suffered by UK in the 1920s.
5. Models are too subjective and Vague.
6. Keynesian critique that economies will recover without government intervention. Leaving it to market forces may take a very long time to move economy back to full capacity. Their policy prescriptions for the Great Depression are considered to be 'nihilistic' because they advocated no government intervention. They have also been criticised for shaping their political beliefs into economic policy.

Books on Austrian Economics

• Austrian economics at Amazon.co.uk
• Austrian economics at Amazon.com

External Links

• Austrian School of Economics at Wikipedia
• Criticism of Austrian Economics
• What is Austrian Economics at Mises.org

Top 10 Reasons for studying Economics

Should I study Economics? Here are 10 absolutely foolproof reasons for studying economics.

1. Economic Forecaster.

As an economist, you can make a living from predicting future economic events. The key to being a good economic forecaster is to use a mixture of dice and lottery numbers. (some economists make the mistake of using just lottery numbers, but this can lead to really bad forecasting) If this method fails just use the statistics from the previous year; they are always more accurate than the actual predictions of economists.

• Note: Economists have successfully predicted 10 out of the last 2 recessions.

2. You can always give advice.

When the economy enters a recession, you will be able to tell everybody why the economy is in a recession. Also, you will be able to suggest several conflicting reasons as to how we can get out of a recession. This will simultaneously, both confuse and impress everybody; but it doesn't matter because nobody ever listen to economists.

3. Diminishing Returns.

When you get ill from drinking 10 pints of beer in one night, you will be able to impress your parents with the knowledge that the law of diminishing returns is actually perfectly correct. As a side effect, you may also learn about opportunity cost:

• Spending £40 on drink equals hangover.

4. Rational Behaviour

Economics assumes people are rational. Economics assumes that people choose the activity which optimises our utility. When people want to buy a season ticket to watch Leeds United, you can tell them this is irrational behaviour. However, the Leeds United supporter will definitely appreciate the cogency of your economic reasoning and will, more than likely, start supporting Doncaster Rovers with immediate effect.

5. Economics is a very humorous subject

Did you know that you can rearrange Economics to get "comic nose." If, this alone, was not sufficient proof of the hilarity endemic in the subject of Economics, try these economics jokes:

• How many Free Market economists does it take to change a light bulb? None, in the long run, it will change of its own accord.
• How many Marxists does it take to change a light bulb? None, smash the light bulb, a light bulb is a mere representation of the capitalist ideology that gives a feeble light, rather than the True source which is the sun.

6. Economics gets you a high paid job

Actually, this is the only reason people study economics. Unless, of course, you have a strange desire to be an economics teacher; in which case you will enjoy your students repeatedly asking you the question; "Why didn't you get a proper job in the city, Sir?"

7. It's better than studying Geography

True, but purists may argue this doesn't prove very much.

8. Economies of Scale

When you forget your wife's / girlfriends birthday you can say that you were merely seeking to maximise economies of scale and productive efficiency, because you are waiting to get her a really big present at Christmas. This always goes down very well.

• (In the incredibly unlikely event it doesn't, don't forget to also check out: www.nofriendsandsingleconomist.com)

9. However - On the Other Hand

Economics is the only subject where contradicting yourself is seen as a highly desirable attribute. To double the mark on your economics essays, just say after each paragraph: however, on the other hand, this is probably not true at all...

10. You will Know Why you are Unemployed

When you are standing in the unemployment queue, you will be able to tell everyone the type of unemployment they are suffering from. This will greatly endear you to the ranks of the unemployed; who will definitely not, sarcastically, ask you;

"If you know everything, how come you haven't got a job then?

See also: 10 Principles of Economics Explained

Applying economics in everyday life

References:

• Funny Economics

UK Growth downgraded to 0.2%

With the Olympics around the corner, there is hope that the UK may finally come out of the double dip recession this summer. However, the IMF have recently downgraded UK growth for 2012 to a miserly 0.2%, and the outlook still looks pretty grim. (By contrast the Office for Budget Responsibility, in March predicted 0.8 per cent growth for the UK over 2012, followed by 2 per cent in 2013.)

A discussion of some of the different factors that have caused continued recession in the UK.

1. Euro-crisis - uncertainty and recession in Eurozone affecting UK exports and investment levels in UK
2. Bank Lending - Banks reluctance to lend to firms is stifling investment and economic recovery.
3. Government spending cuts - Cuts in government spending have led to a fall in demand and also a subsequent fall in consumer spending.
4. Global downturn. The UK is being affected by global economic slowdown. (though other parts of the world are still posting positive economic growth)
5. Reduced real wages. Combination of real wage cuts and higher commodity inflation has squeezed disposable incomes in past few years.
6. Weakness of housing market
7. Low levels of UK consumer spending
8. Government spending under Labour

Have your say at:

• Who is to blame for the double dip recession?

Government Spending Under Labour

Source: A view of UK public spending

Government spending under labour rose from 36% of GDP to 46% by 2008-09  - how much is that to blame for the UK's current economic woes?

• Government spending under labour

Spanish CrisisUK growth may have been downgraded, but it is still possible to see how the UK can recover. Spain by contrast faces a real economic crisis, with seemingly no way out. Spain makes the UK look positively booming.

• Spanish economic crisis

What EURO Economic Crisis?

A former chief German banker asks - is there really a crisis in the Eurozone? It's not just the UK where bankers can be out of touch. - What Euro crisis? Readers Questions

• How Manipulation of Libor increases bank profits
• Where does the money come from?
• How Does the EU effect UK debt?

Spanish Unemployment


The remorseless rise in Spanish Unemployment

Saving the Euro and Printing Money

Does Germany actually benefit from the Euro?

This is a question many people in Germany are asking (39% of Germans are no longer in favour of the Euro. In Germany the issue is often framed in terms of how much the bailouts will cost. But, another very important issue is the extent to which the German export sector have benefited from an undervaluation in their exports. If Germany left the Euro, the D-Mark would considerably appreciate, reducing the competitiveness of German exports - and helping to reduce the large German current account surplus.

• Costs and benefits of the Euro to Germany

What Policies are needed to save the Euro?

There are different approaches. Some frame the question as either debt pooling (fiscal union) or printing money to buy bonds and prevent rising bond yields) To save the Euro, there needs to be a combination of some or all of the following:

1. Joint liability of European debt. Eurobonds where debt is pooled.
2. Direct recapitalisation of European banks
3. Printing Money to buy bonds and provide liquidity for governments facing liquidity crisis.
4. Economic growth to give countries a chance to improve tax revenues and reduce debt / GDP ratios
5. Restoring competitiveness amongst peripheral Eurozone countries who are struggling in the fixed exchange rate of the Euro.
6. Structural reform / supply side policies which improves tax collection and improves productivity and competitiveness.

• More detail on Policies to save the Euro

 To Print or Not to Print?

The big question for Central Banks is should they be printing money, and if so how much?

• Readers Quesiont: Why is the Fed reluctant to print more money?

Would it help to if Italians and Greeks bought Italian and Greek Bonds?

• An initiative for Italian footballers to show their patriotism and buy Italian bonds. Buying domestic bonds

The Recession and Trend Rate of Growth

Will the UK ever recover the lost output of this recession? Has the recession reduced the long-run trend rate? Is the economic downturn actually a supply side phenomenon?

• Recession and Trend rate of growth

Readers Questions

• What is meant by bank recapitalisation? 

Debt as % of GDP in G7

• Italian Debt Crisis

Divergence in Bond Yields

 

The fall in UK and German bond yields almost mirrors the rise in Spanish and Italian bonds. I didn't put Greece on there because it's off the scale.

There is a flight to safety. Does the UK deserve to be seen as safe?

One thing is that it reduces the borrowing costs for UK and Germany very nicely. But, Spain and Italy are in a fix with  interest payments taking up a higher % of their tax revenues making it difficult to deal with underlying debt.

One thing is certain, there is no single bond market in the Eurozone.

Factors that influence bond yields.

Eurobonds

1970s Revisited?

I was watching the very good TV programme about the 1970s. 1973-74 was one of the most turbulent years in British economic history - a boom and bust, rapid inflation, strikes, a 3 day week, petrol rationing - even the first experiments with credit cards, leading to our first credit binge and later bust. There were few things the 1970s didn't have. (Economy of the 1970s)

 

30 years later and there are some unwelcome parallels. Persistent stagflation (inflation + negative growth) Rising oil prices, a much more serious credit binge and consequent debt recovery.

In some ways, things aren't as bad as the 1970s. Inflation of 3.5% is not comparable to the inflation of 20%. The current threat of a petrol blockade is pretty insignificant compared to the actual reality of a three day week. TV off at 10.30pm. Life was very different.

But, at least, the 1970s didn't have such a persistent recession and mass unemployment.

Double Dip Recession

Figures published by ONS today, show that the UK is officially in a double dip recession. Some may wave the figures away saying it is only small fall - and it is just because of a big fall in construction. But, it is remarkable and worrying to see such a prolonged fall in GDP. (Bear in mind the UK's long run trend rate is 2.5%) But, GDP is still lower than in the 2008 peak. That's three years of falling living standards.

More on double dip recession

IMF Bailout

The 1970s, was also a time when the UK needed its only IMF bailout (UK national debt was only around 75% of GDP). These days, the IMF have much bigger challenges than a relatively small debt of 75%. The big concern for the IMF is that even a firewall of £1 trillion does nothing to tackle the underlying problems of the Eurozone.

• Purpose of IMF rescue Fund

Scottish Independence

The discovery of oil in the north Sea during the 1970s, was a factor in contributing to the re-emergence of Scottish nationalism. Economics looks to be the decisive issue in swaying whether people will vote for independence.

• This is a brief look at economic consequences of Scottish independence.

Recent Inflation Graph and blog posts

I have been updating a different economics blog.

What would a world without oil look like?

Debt spirals explained - the situation facing many EU countries

Why is current recession so severe?

What is the long run trend rate of economic growth? - has it been reduced in UK since recession?


Inflation in the UK remains relatively high given the state of the economy. Latest UK inflation