Long Term Effects of Recession

A recession is a period of negative economic growth characterised by rising unemployment. In the short term, recessions can have various costs:

• Loss of income
• Firms going bankrupt.
• Psychological and health problems of the unemployed
• Higher government borrowing (lower tax receipts and higher benefit spending)

But, what about the long term effects of recession?

• Is there just a sweeping away of inefficient firms enabling a rebounding of economic growth and higher productivity? - or
• Is there a permanent loss of output and a persistent loss of economic welfare, even when the recession is officially over?
  

Long Term Effects of Recessions

Levels of Education. Studies in US, show that prolonged periods of unemployment lead to some students being unable to afford college education. It can also lead to lower levels of education amongst under 7s. If recession does effect levels of education then there will be a corresponding long-term effect on earnings of those affected. It will also lead to higher long-term inequality. Those without access to education will typically face lower income levels in later life.

• However, in the UK, student numbers have increased during the recession as students seek to avoid a difficult job market and go to university instead.. One factor is that education is more expensive in the US, therefore recession and lower income in the US leads to lower demand. However, as fees in the UK rise, recession may increasingly deter education.

Private Investment

Recessions have a significant deterrent effect on private investment. Investment has been particularly badly affected in the 2008-12 downturn because of limited access to bank credit. If the recession is prolonged, this can have a long-term impact on levels of capital and productive capacity.

Lost Output

In some short-lived recessions, output has often bounced back and caught up with the lost output. This has enabled the economy to keep the long-run trend rate of growth. For example, in 1994, the UK economy grew by nearly 4% which helped catch up 'lost output' of the 1991-92 recession, and maintain a long-run trend rate of 2.5%.

Bounce after recession of 1981 and 1991.

However, with a longer 'balance sheet recession', there is evidence that output has been permanently lost. This balance sheet recession has not just been a temporary fall in demand due to higher interest rates. It has involved a credit crunch, lower bank lending, and falling asset prices. It has lasted much longer and caused a much more prolonged fall in GDP.

Europe's Lost Output

source: Europe's Gap

US Output and Potential Output

source

Even the most optimistic forecasts for recovery suggest slow growth. There is going to be no bounce to catch up with lost output. The longer the recession lasts, the greater the risk that output will fall below the trend of potential output.

Business

Recessions make it more difficult for new firms to start. There are examples of firms who have been able to start in the middle of a recession (Microsoft 1975), CNN (1980) Disney (1923). But, in recession, typically business-starts fall dramatically. Also existing firms are at risk of bankruptcy. In 2008 in the US, 43,500 businesses filed for bankruptcy, up from 28,300 businesses in 2007. Some argue that a recession 'weeds out' inefficient firms. But, even good, efficient firms can go out of business due to temporary liquidity problems.

It is possible, some firms merely delay start-up, but for some firms, a few years may mean the window of opportunity passes and two years later is too late.

Impact on Government Borrowing

This permanently lost output also means permanently lost tax revenues. In this current recession, many economies have felt the need to reduce government spending as a result of the cyclical increase in their budget deficit (especially countries in the Eurozone). However, this cut in government spending has adversely affected capital investment and the rate of economic growth. It is part of the reason why the recession has been difficult to overcome. Therefore, if recessions cause an unsustainable rise in government borrowing, it may cause governments (rightly or wrongly) to cut spending and increase taxes which further damages economic growth in both the short term and long-term.

Inequality

The biggest cause of inequality and relative poverty is unemployment. A rise in in unemployment leads to lower income and can harm nutritional intake and quality of life. In the US, there are also impacts upon health care, with unemployment causing a fall in health care insurance. Poorer health care and nutritional levels can impact in the long-term.

Impact on Younger Generation

Effects of recession on younger workers. source

A recession tends to have a greater impact on younger workers rather than older workers.
In the long term, this will impact young peoples future earning potential. It is hard to recovery from a period of unemployment in early working life. It leaves a gap in your CV and damages future employment and promotion prospects.

In addition, highly concentrated youth unemployment can lead to a rise in social problems. Higher unemployment rates can lead to higher rates of crime, vandalism and social dissatisfaction. This feeling of social exclusion can be difficult to eradicate when the economy gets out of recession.

• A culture of unemployment amongst young people definitely has long-term effects.

Related

• What determines the long-term effects of recession?
  
• Causes of recession
• Problems of recovering from recession
  

British vs French Economy

A good Central Banker is supposed to be boring. But, the French are trying to make it a little more interesting by suggesting other economies are even worse than theirs. A kind of playground, 'my Dad earns more money than your dad'

Christian Noyer, the head of the Bank of France said: "When I look at our British friends, who are even more indebted than us and carrying a bigger deficit, what I see is that the ratings agencies so far don't seem to have noticed."

Now, the rating agencies have a pretty poor track record. It wouldn't be the first time the rating agencies have given a triple AAA rating where it wasn't deserved. Yet, the markets seem to agree with the rating agencies. Despite a bigger budget deficit, bond yields on UK debt have fallen in 2011, in France they have risen. There is great fear of any Euro bond (apart from Germany). But, outside of the Euro, the UK has been relatively insulated.



The difference between British and French situation is that France is in the Single Currency, the UK isn't. And it's rather worrying that the head of the Bank of France hasn't understood why there has been a sharp divergence in bond yields between Eurozone members and those outside.



It may be unfair. Perhaps UK doesn't 'deserve' such a low bond yield compared to other European countries. Perhaps the UK was just lucky to stay out of Euro. But, that's the drawback of being in a single currency, with no lender of last resort and no ability to devalue. The problem is that the EU never give the impression they appreciate why they are in such difficulty.

The American credit rating agency Fitch, concluded that a "comprehensive solution" to the eurozone crisis was "technically and politically beyond reach" And I tend to agree with them.

French National Debt

UK National Debt


UK debt has been increasing at a faster rate because of a bigger budget deficit.

• UK national debt
• French national debt

Difference Between the EU and Euro

I often find people talk of the European Union and the Euro (single currency) as interchangeable ideas. Recently, the German leader Angela Merkel stated defending the Euro was essential for maintaining the post war gains of the European Union. The new Italian new 'technocrat' leader Mario Monti warned that a breakup of the Euro would bring its users "back to the 1950s." - (before the creation of EEC.) Yet, arguably, the European Union would be a lot stronger without the Euro or at least the Euro in a very different format.

The Ideal of European Integration

The post war development of Europe is one of humanity's great achievements. We went from a conflict perpetually at war, to a continent at peace (with the odd exception in the Balkans). The European Economic Community, for all its failings helped foster greater ideals of integration. With free trade throughout the European Union we benefited from a golden age of economic growth, low unemployment and prosperity. Whatever bureaucratic failings may occur in the EU, I will always remain a broad supporter of this ideal of bringing European countries together.

The Euro Is Not Aiding European Harmony and Prosperity.

The problem is that European leaders felt having a single currency (the Euro) was a natural extension of this ideal of economic and political integration. Southern European economies were particularly keen to gain the benefits of being tied to the German economy. (Italy was one of strongest supporters of Euro). Countries felt joining the Euro would be an easy ticket to low interest rates, low inflation and high economic growth. (in fact the opposite has occurred).

The EU were so keen to go ahead with the single currency that their own 'Maastricht Criteria' were pushed aside to let everyone join. (In 2000, the UK was actually one of few countries who met Maastricht Criteria, though we decided not to join). In the case of Greece the decision to ignore these criteria would prove most damaging.

The problem with the Euro is that it is fundamentally flawed, and because of these fundamental flaws it has an in built deflationary bias which is promoting low growth, high unemployment and increasing division between the different regions in the EU.

Fundamental Flaws of the Euro

1. No Lender of Last Resort. This means liquidity crisis come quickly and with great force. It is why Greece, Ireland, Portugal, Italy, Spain (and more to come) have see such a devastating rise in borrowing costs. If the UK had been in the Euro, the same would have happened to us. Problems of Euro in recession
   
2. Uncompetitive Countries. Countries in the south of Europe have seen a rise in inflation relative to Germany. This has left them uncompetitive, leading to lower exports and lower growth. But, because they are in the Euro, they can't devalue to restore competitiveness. They are left with sluggish growth.
3. Austerity. The response to the EU debt crisis has been to push spending cuts on country. No matter how steep the spending cuts, these have singularly failed to reassure bond markets. Bond yields have continued to rise regardless. THe only thing spending cuts have achieved is to push the south of Europe into a potentially damaging recession, lower tax revenues and higher debt to GDP. IN response the European bureaucrats and leaders shout 'more austerity'. The outcome is unemployment, recession and greater disharmony.
4. Not an Optimal Currency Area - geographical immobilities
5. No real fiscal union - only grudging promises of help
   

More: Problems of the Euro.

• The Germans don't want to bailout southern countries who have run up large budget deficits.
• The south don't want to be stuck in a deflationary trap.

Both, are right. It shouldn't be like this. With the single currency and common monetary policy, we only have a recipe for falling living standards and increased social division. This doesn't help Europe. It is the Euro and the failings of the ECB which is threatening the stability of Europe.

Related

• Why is EU trying so hard to saving the Euro - reasons to justify the defence of the Euro.

Is France Next Bond Crisis?

Despite similar public sector debt to Germany France (85% of GDP) is at risk of becoming the next target for bond investors, as sellers push the interest rate on French debt up.

In the real world, investors are selling all Eurobonds apart from Germany. France is looking like the next target for a panic sell off.

The ECB adamantly refuse to act as lender of last resort. As Rome burns, the ECB watch their inflation targets. But, if they don't intervene what will stop the Euro crisis? - ECB and Money Creation

One Year Bond Yields - Spread v Germany and France Bond Yields

French National Debt

• 
• In Nov. 2011, French national debt stands at 1.7 trillion Euros - 85% of GDP.
  • Forecast for end of 2012 is 90% of GDP.
  • France's budget deficit is 5.8% of GDP
• France National Debt
• Spiegel online

Related

• Euro Debt crisis

Inflating Away Our Debt

Inflation reduces the value of money. This reduces the real value of your debt and also the real value of your savings. Therefore periods of high inflation tend to be good news for borrowers, but bad for savers. This is particularly the case if we have high inflation during a period of very low interest rates.

Inflation and Interest Rates since 1900

In periods where inflation is higher than interest rates, savers are losing out.

UK 2011

From one perspective, it is curious that with inflation of 5%, investors are very willing to buy UK bonds pushing interest rates down to 2.2% on 10 year bonds (Nov, 2011). What this means is that investors prefer to hold bonds with a negative real interest rate rather than use their funds to invest in other areas.

The good news for the UK is that with inflation of 5%, we are effectively 'inflating' away part of our debt. With inflation it is much easier to reduce your debt to GDP ratio.

Simple Example Showing Affect of Inflation on Debt.

• Suppose government borrow £1,000bn and nominal GDP is £1,000bn.
• Supposed tax revenues = £400bn (40% of GDP)
• The debt to GDP ratio is 100%.

• Suppose then we have inflation of 100%, and the level of former debt stays at £1,000bn.
• Because of inflation, nominal GDP increases to £2,000bn.
• The debt to GDP ratio will fall to 50%
• Also, if tax rates stay the same, tax revenue will increase to £800bn, making it easier to meet debt interest payments.

This scenario, is bad news for savers who see a real fall in the value of their savings. In the above case, savers will see the value of their bonds fall by 50%. This kind of inflation is effectively a partial default.

But, for the government and borrowers, it is a 'lucky' event which makes the task of debt reduction easier. However, if a country gains a reputation for having 'unexpected inflation' it will become more difficult to sell future debt. It means in the future bond investors will demand higher interest rates to compensate for risk. - There are only so many times you can get away with 'inflating away your debt'

Usually, the threat of inflation would push up bond yields as investors don't want to have this kind of negative interest rate. However, at the moment, pension funds don't want to invest in the stock market or invest in long term capital investment. They only want the security of government bonds. Therefore, in the current liquidity trap, the government can take advantage of borrowing at low interest rates.

Also, part of the reason that investors are willing to buy bonds at such low interest rates, is that they really do expect inflation to fall next year. The current inflation of 5% in 2011 is due to temporary factors such as higher taxes and impact of devaluation. Because markets expect inflation to fall next year, they are more willing to hold UK bonds.

Also, markets fear UK growth will be very low. This risk of a second recession means that the stock market and other investments are still unattractive. Pension funds would rather have the security of bonds rather than risk putting money elsewhere.

Bond yields have also benefited from

• The governments stringent spending cuts.
• UK yields have also been helped by having a lender of last resort (unlike Italy).

Inflation Unfair on Savers

Inflation invariably reduces real wealth of savers. Many pressure groups representing savers argue for immediate action to protect the value of their savings i.e. higher interest rates to reduce inflation and increase real interest rates.

However, the government and Central Bank have to weigh up the different costs.

It is unfortunate the middle classes see a small fall in the value of their savings. However, arguably it would be a much bigger cost to society, if higher interest rates pushed economy back into recession and a significant rise in unemployment.

Low interest rates reduce living standards, but it is not comparable to the reduction in living standards from unemployment and a prolonged recession.

Savers Also need Economic Growth

Savers are getting such a poor deal because of feeble prospects over economic growth. If the economy recovered with strong economic growth, pension funds would have the confidence to invest in shares and capital investment. They wouldn't feel tied to buying bonds with negative real interest rates.

Therefore, although it is unfortunate savers have negative real interest rates, it is definitely not in their interest to have a sudden rise in interest rates which pushes the economy back into recession.

Related

• Definition of inflation
• Costs of inflation
• Historical interest rates
  

Options for the Eurozone and Euro

The EU gives the impression of stumbling through the crisis. There is an attempt to deal with issues as they come up, without tackling the fundamental issues underlying the crisis.

In particular, in response to rising bond yields, there is a rush to try to reduce budget deficits and reassure markets. But, this approach is not working. It is not working because:

1. It doesn't address the underlying lack of competitiveness and misaligned exchange rates in southern Europe.
2. It doesn't tackle the need to promote growth in GDP, which will help reduce Debt to GDP ratios.
3. It doesn't reassure markets there will be no liquidity crisis - because there is still no lender of last resort.

See more detail on: Euro Debt Crisis Explained

Options for the Eurozone

1. Internal Devalution, Austerity, Weak bailouts

The current option pursued by the European Union is to

• Reduce spending as much as possible to reduce budget deficits.
• Rely on internal devaluation (lower labour costs to restore competitiveness for the Southern economies)
• Implement structural reforms to restore competitiveness, although these tend to be vague.
  
• Offer a grudging and weak kind of bailout (i.e. the EFSF is guaranteed by countries like, er Italy)
  

The problem of this is that:

1. This is causing lower growth and falling tax revenues. Therefore, markets don't see how the likes of Italy are going to reduce their debt to GDP ratios.
2. Despite austerity measures markets still don't confidence in buying Italian debt because of the fears of recession, and also there is no lender of last resort.
3. The process of restoring competitiveness through this internal devaluation is very slow.
   

If the EU stick to this, we will get prolonged economic stagnation and a serious recession in the south of Europe. There will be a perpetual need to cut spending and try and reduce budget deficits. Internal devaluation may eventually restore some kind of competitiveness (Ireland has been more successful than other) and help promote some kind of economic recovery, but it will take a long time and cause very high levels of unemployment and instability. There will also be persistent pressure from the bond markets. Whether the Euro can surviving bailing out stagnant economies the size of Italy during a decade of economic stagnation is highly debatable.

2. Change the Role of the ECB

At the moment, the ECB seems only interested in preventing the non-existing inflationary threat. The ECB could be reformed to:

• Act as lender of last resort. Buy government bonds without hesitation and give markets confidence.
• Target a higher inflation rate (perhaps as likely as Berlusconi being made an honorary member of the Women's Institute) But, the ECB at least have to see the need to target growth, even at the risk of some higher inflation.
  

3. Break up of the Euro

Concentrate the Euro on only a small group of northern economies who have actually shown a degree of economic harmonisation (Germany, France, Belgium, Netherlands e.t.c). Countries who leave the Euro should honour current contracts in Euros, but new contracts should be based on their own currency (new Lira, New Drachma) These new currencies will significantly devalue. This has both costs and benefits.

• The rapid devaluation will restore competitiveness enabling an increase in export demand
• The devaluation would probably cause capital flight as investors seek safe havens in the 'strong Euro' and away from the south.
• The fragmentation of the Euro could cause great turmoil in the EU. However, it may still be a better alternative than the prolonged recession likely with current policies.

4. Fiscal Union

The other option is to go for broke and have a complete fiscal union. i.e. there would be no Italian bonds, no German bonds, only Euro bonds. This would prevent contagion for weak countries. It would reduce interest rates enabling a more ordered austerity program. It should give better chances for growth.

However, it opens a range of other issues.

• Can the EU impose a degree of fiscal discipline on countries with poor track records.
• Will German taxpayers be willing to bite paying for Italian profligacy.
• Is fiscal union enough? It still doesn't promote competitiveness and economic growth.
  

Related

• Potential impact of debt crisis on UK
• Solutions to EU crisis
  

Economic Problems of Italy

Italy is facing a economic serious crisis with bond yields rising close to 7%. They also face the prospect of recession and slow growth in the coming years.

Bond Yields on UK, Italian and German Debt


Firstly, there is a significant difference between Greece and Italy. Greece was fundamentally bankrupt. It's budget deficit, and public sector debt was too large for it to cope. A debt restructuring was inevitable.

source: budget debt EU

Italy is actually running a primary budget surplus (this means if we exclude the cost of interest payments on its debt, Italy has a 'primary' budget surplus - very different to the UK) Italy doesn't have the highest public sector net debt in the EU either.

source: FT

Italy's fiscal deficit is lower than many other countries.

It seems bizarre a country with a primary budget surplus can be facing a liquidity crisis that Italy is.

Reasons for Italian Crisis

Recession. Austerity packages (spending cuts) and fears about the prospects of the Eurozone have precipitated a fall in consumer spending and economic growth in Italy. It is forecast Italy will remain in recession in 2012 and 2013. This negative growth will lead to a fall in tax revenues and higher government spending on unemployment benefits. Markets don't want to buy Italian debt because of fears over lack of economic growth will make it very difficult to reduce their debt to GDP ratio.

Poor Growth Record

Due to a combination of political instability, corruption and poor productivity growth, Italy has developed a poor track record of economic growth in past two decades.

source: economist

Long Term Debt.

Though Italy's budget deficit (annual deficit) is quite low, public sector debt is over 110% of GDP, which is giving cause for concern. The problem is that it is quite difficult to reduce this debt / GDP ratio given - how much they spend on interest payments, and the poor prospects for GDP Growth.

Ageing Population.

The long term debt problem is not helped by Italy's ageing population. This will reduce income tax revenues and require greater commitment to state pensions over the next few years. Italy has one of the lowest birth rates in the world.

Fundamental Uncompetitiveness.

Since joining the Euro, Italy has seen its relative competitiveness decline. Labour costs have risen 40% compared to Germany; this has contributed to a 70% fall in direct investment since 2007. Like Greece and Portugal, Italy can't devalue so it is left with uncompetitive exports. This uncompetitiveness leads to lower economic growth and more pressure on debt/GDP ratio.

No Lender of Last Resort

Italy is not bankrupt, but it may experience a liquidity crisis (it may be unable to 'roll over its debt' i.e. sell enough bonds to meet current budget requirements in short term). This liquidity shortage should be quite a small risk. But, because there is no lender of last resort for Italy (i.e. ECB will not buy Italian bonds to roll over debt) Markets find Italian debt much less appealing. If there was a guaranteed lender of last resort, Italian bond yields would be much lower. People would have much more confidence in holding Italian debt. However, because there are fears over liquidity shortages this has pushed up bond yields; this increase in bond yields has increased the cost of servicing Italy's debt


Conclusion.

Italy suffers from:

• Having wrong exchange rate. They have lost competitiveness and can't devalue leading to lower growth
  
• Monetary policy is too tight for Italian economy.
• There is no lender of last resort.
• EU austerity measures (spending cuts) are forcing Italy back into recession leading to a predicted slump in tax revenues. This is making markets nervous about future prospects for Italy.
• There seem no practical solutions to returning to strong growth. Again the only medicine seems to be 'spending cuts' and internal devaluation. But, this will be a long drawn out process.
  
• Political instability. Lack of strong cohesive government makes markets more nervous to hold Italian debt.

Similarities between Italy and Greece.
Both countries:

• Share decline in competitiveness
• Would benefit from devaluation, but in Euro can't
• Are experiencing high unemployment and economic stagnation
• Must regret being in the Euro.
  

Related

• Facts on European Debt Crisis
• Bond Yields on EU debt
• Is the UK like Greece and Italy?
  

Is the UK like Greece and Italy?

With all the turmoil in the Euro, how likely is the UK to face similar debt crisis as Greece, Italy, Spain and Ireland?

On some measures there is a disturbing similarity.

Public sector debt as % of GDP

Facts on European debt crisis

Annual Budget Deficit


• The UK's budget deficit is one of highest in EU (after Greece and Ireland's 2010 budget deficit)
• The UK economy is very closely linked to the Eurozone; if Europe enters a recession, this is likely to adversely affect the UK economy.
• Despite recent growth figures there are signs that the UK economy is stuck in an economic slowdown.

However, I don't think we need to fear becoming the next Greece, Ireland or Italy. This is why

• Bank of England is willing to act as lender of last resort - buying bonds in a liquidity shortage. Markets have greater faith in countries who have independent Central Bank who is is willing to buy government bonds. If Italy experiences temporary difficulties in selling government debt, there is no Central Bank to step in. They have to go through the whole rigmorole of going to the EU asking for loan. But, this loan usually involves interminable political wranglings. Understandably, markets fear there is no mechanism to deal with liquidity shortages. Therefore, investors are less willing to hold debt held by Eurozone economies.

Bond yields have stayed low in UK

• • 
  • 
    

  Bond yields on EU Debt

• Low Interest Payments. UK Debt interest payments are manageable at only around 3% of GDP (£48bn)
• Longer debt maturity. The UK has a higher % of debt denominated on bonds with long maturity (e.g. greater than 10 years) therefore there is less pressure to sell new bonds.
• Historical national debt. As a % of GDP, UK public sector debt has been higher in the past. (National debt facts)
  
• Spending Cuts. Markets have been reassured government is committed to reducing structural deficit.
• Greater Flexibility. The UK has greater flexibility than Eurozone economies. Whilst the UK government cut spending leading to unemployment and lower demand, at least UK Central Bank have been able to pursue quantitative easing to provide some monetary stimulus. Also, the UK has benefited from the depreciation in sterling which helps to boost domestic demand.

It doesn't mean the UK economy is safe. The debt to GDP ratio will only improve when the UK economy returns to its long run trend rate of growth. However, it would require a very sharp deterioration in the UK economy for us to face the challenges facing some of the Euro member countries.

Related

• If UK had been in the Euro

Euro Bailout

The recent Euro Bail Out was greeted with some relief by markets. At least European leaders could agree on something. But, bond spreads have continued to rise and the fundamental problems remain.

Some notes from the recent bailout.

• Firstly, as many widely expected a European country (Greece 50% cut in debt) has defaulted on its debts for the first time since after Second World War. This is still quite a significant milestone sovereign debt default in an advanced country is very rare. - Note for many months, the EU had hoped to muddle on and avoid Greek debt, but this just shows a misplaced optimism.
• Now sovereign debt default is a reality, investors will be repricing many other countries debt. It is likely to put increased pressure on Portugal, Italy and Spain and lead to higher bond yields.
• The bailout does nothing to tackle the collapse in money supply that is occurring in countries like Portugal. As part of the deal, the Germans insisted that the ECB stop any bond purchases. (Presumably we still have to worry about inflation despite a collapse in the money supply and nominal GDP that is occurring in the south of Europe)
• A new dynamic is that The EU are hoping that China will become a major beneficiary of the new EFSF fund. China will demand in return free access to European markets and freedom to buy advanced technologies. No mention was made of political issues like human rights abuses, but if China is to become the EU's saviour expect the EU to suddenly go quiet on issues such as Tibet.
• As part of the new deal the EU has new regulations with the powers of 'rigorous surveillance and laws enforcing balanced budgets. Just what you need when when you've got a deep recession, some EU commissionaire to impose more spending cuts and austerity on you.

What The Bailout doesn't do

• This deal doesn't solve the 30% gap in competitiveness between the North and South. The EU kind of hope that a decade of 'internal devaluation' will eventually restore competitiveness. This means a decade of mass unemployment and stagnant growth.
• It Forbids any chance of monetary stimulus to help the beleaguered south escape debt deflation and mass unemployment.
• There is no fiscal union just a 'stability union' There is no joint bond issuance only greater scrutiny of other countries debt.

Related

• European debt crisis
• Problems with Greece Economy
• UK and Euro Crisis

Video Animation on Bailout

• Europe's Punishment Union Telegraph
• Problems of G20 Growth at Guardian
• EU Bailout animation
  

Failures of the ECB

I was writing a short piece on the functions of a Central Bank. The interesting thing is the extent to which the ECB is failing to carry out certain functions. This failure of the ECB threatens to undermine the whole EU economy.

Failures of

Ignoring Economic Growth. A Central Bank definitely has to target low inflation, but not to the exclusion of other macroeconomic objectives such as economic growth and unemployment. The ECB seem to give the impression that inflation is the only thing they care about. As the global economy was slowing down, the ECB increased interest rates this year. Yet, to keep inflation on target at the cost of a recession, is a pyrrhic victory - especially when the inflation is temporary anyway.

Unwillingness to Buy Government Bonds.

Why does the UK have low interest rates on government bonds, but countries like Italy and Portugal have much higher bond rates, despite similar levels of borrowing? Markets know the ECB wouldn't buy Italian bonds in a liquidity crunch. Even one month's shortage would cause great problems and therefore markets push up interest rates on Italian bonds. Occasionally, the ECB has bought bonds, but when they buy bonds they always do it with a loud feeling of guilt and they say they will reverse it as soon as possible. The ECB successfully lose any confidence the market may have in the operation. Paul De Grauwe explains in more detail at Vox

The impact of this decision, is that it puts greater pressure on European governments to pursue deflationary fiscal policy at a time when they need the opposite.

Unwillingness to Pursue Unconventional Monetary Policy

The ECB seem stuck in past economic situations. They don't seem to realise that in the Eurozone, especially south, there is a real threat of deflation and prolonged recession. Faced with this kind of crisis, a Central Bank should be galvanised to do everything in its power to avoid recession. This may mean a temporarily higher inflation target for countries in the north of Europe, it may mean unconventional monetary policies such as quantitative easing. But, the problem is they have an almost religious devotion to low inflation and can't see wider issues.

Related

• Criticisms of ECB

Historical National Debt

see: Historical national debt

A Spike in Inflation and other Questions

Recent readers questions and posts on my other economics blog

• Bankers vs People - Another look at the role of bankers in current crisis. When the economy experiences real difficulties it can become tempting to lay blame on a particular groups of people (and bankers make an attractive target). Have your say.
  
  
• In a week when UK inflation reached 5%, a look at whether The Bank of England should worry about inflation?

• Pros and cons of inequality - the extent to which inequality is desirable in a free market economy.
  
• Is it possible to have negative interest rates? - The difficulties of monetary policy when interest rates reach 0%
  
• Is inflation caused by economic growth?
• Could you explain pegging currency to dollar? - a look at how and why China pegs its currency to the dollar.
• Chain Weighted inflation measure - If the price of a good rises, we tend to switch to cheaper goods and don't buy the more expensive ones, therefore according to this measure, conventional inflation arguably over-estimate inflation rates. (not good news for those who have benefits set by RPI and feel it underestimates changes in living costs
  

Don't forget you're always welcome to ask economics question

Understanding Financial Crisis

Readers Question. I have recently been trying to better understand the financial crisis and it has been very useful, however I am curious to your own opinions, as the articles are very neutral.

Where possible, I try to avoid preconceived ideology / expectations. Of course like everyone I have my preferences and prejudices. Not everyone would think my articles neutral.

Bankers can make millions from a recession, and as people suffer in Greece for example, they continue to do so, making profit from the taxpayer´s bailouts as austerity measures leave thousands homeless and without work. I for one am mad as hell and I want to clarify that I have my facts straight.s

Some bankers can make millions from a recession and financial crisis, though some have also lost their jobs. Many had their job saved through government intervention (which wouldn't have occurred in other industries) Even the Bank of England have issued a blunt warning about unjustified bank bonuses [BBC]

Subprime mortgages and CDOs and derivatives were made legal under Greenspan, right?

Alan Greenspan was chairman of the Federal Reserve (1987-2006). He primarily was responsible for setting interest rates, though the Federal Reserve do have a role in overseeing aspects of the financial system. (see: mistakes of Alan Greenspan)

During the 1980s and 1990s there was a general move to deregulate the financial sector in both UK and US. This was partly due to legislation by governments; sometimes it was the Federal Reserve, e.g. adopting different interpretations more favourable to banks (e.g. in 1996, Fed reinterpreted Glass-Steagall act - banks could now devote up to 25% of business to investment banking.)
Also, there is an element that financial institutions were creative in selling and expanding new financial instruments that didn't fall under any regulation. One problem is that it wasn't always clear who was responsible for financial regulation (e.g. Central Bank or government). The outcome of this financial deregulation was:

1. Easier to lend subprime mortgages (less checks on people's incomes - especially in US)
2. Easier to buy and sell complex financial derivatives.
3. Banks able to take on more risky (and profitable) lending practises.
4. Greater competition between banks in attracting custom.
5. In the UK many (non-profit) building societies became public companies listed on the stock market. This changed their business model. They were more likely to lend money with smaller reserve ratios, e.g. Northern Rock were borrowing money to lend for profitable loans. - This led to liquidity shortage at start of credit crunch.

People were falsely sold mortgages by banks who then bet against the said mortgage, so as people were evicted, bankers got fatter.

Yes, mortgages were miss sold. Mainly this problem was confined to the US. (problems US housing market) But, banks didn't benefit when people started to default. In fact banks lost a significant amount of money because people defaulted and house prices started to fall; therefore banks could only recover a fraction of initial loan. Many mortgage companies went bankrupt.
Also, as a result of US mortgage defaults, many banks (e.g. European banks) who had bought these CDO's and sub-prime mortgage derivatives lost money too. It was because these mortgage bundles were sold on, that problems in US subprime market became widespread leading to global credit crunch. See: Credit Crunch Explained

The first UK bailout, as you say in one blog, was to revive the banks so they would begin lending again. That didn´t happen.

• True, lending remained very low. However, the main focus of the UK bank bailout was to prevent banks going bust, which would have caused a catastrophic decline in confidence and possible 'runs on the bank' (UK Bank bailout)
• Quantitative easing was a different program involving creating money and buying bonds from commercial banks. Banks only increased lending in a limited way in response to this quantitative easing. But, QE is not a 'bailout'
  
• In one sense lending didn't pick up, but the bank bailout did prevent a collapse in the financial system (bank failures were one of main reasons for the depth of the Great Depression in 1930s).

The Eurozone bailouts are now paying disappointed investors, through public money, rather than going to the people, who are without blame. This is lunacy, and yet nobody seems to be screaming it from the rooftops. Why??

The Eurozone bailouts are different. Here we are bailing out government debt, and each case is a little different.

Greece had a fundamental deficit before the crisis and has mismanaged its finances very badly.
Ireland had very low government borrowing until 2007. But then the Irish banks lost a fortune. The Irish government had to bail out the Irish banks (arguably, they shouldn't have given so much public money, e.g. Bank shareholders should have accepted much greater losses). But, after bailing out the Irish banks, Irish government debt rose rapidly and the Irish government needed its own bailout. So in Ireland's case it is definitely a case of taxpayers 'paying' for the mistakes of their big banks.

It seems the only people writing about this obscenity without censorship are the protestors of the 15-M movement in Spain and the Occupy movement which, quite rightly, has support globally.

No, there are economists who have criticised many responses to the current crisis. e.g. Nobel economist Joseph Stiglitz suggested 'let the banks fail'

My personal belief is that governments are slaves to the financial industry and big multinationals as much as the rest of us; if not they couldn´t possibly vote yes to these bailouts while (in Greece´s case) demanding that the people pay for banker´s greed and corrupt practices through austerity measures which seem designed to kill society.

I generally disagree with Europe's insistence on so much spending cuts and austerity. In the case of Greece, Spain and Portugal and UK, they are proving counter-productive pushing the economy back into recession.

To be honest, membership of the Euro has made it much more difficult to deal with this crisis because countries have much less flexibility (e.g. can't devalue, can't pursue independent monetary policy, face great pressure to cut costs) It was hoped the Euro would give many economic benefits, but it hasn't.

Since the credit crunch exploded in 2007/08 - there have been no really easy answers.

Initially I thought governments generally did the right thing:

1. Prevented banking collapse (even if bankers didn't deserve to be bailed out, it was still in interest of society to prevent banking collapse)
2. Tried to get out of recession - expansionary fiscal and monetary policy.

More recently I have been disappointed in the response of governments.

1. Banks haven't been effectively regulated to prevent future crisis (though there is time)
2. Governments have made a mistake in rushing to austerity before strong economic recovery. This has risked a double dip recession.
3. In US particular, there is a reluctance to contemplate taxes on the rich and wealthy. There is great political pressure to keep taxes low on the rich. Also there has been an attempt to ignore the fact it was the free market, the financial sector which failed spectacularly.

Related

• Whose to blame for the Credit Crunch?
• How will financial crisis end?
• Solutions to financial crisis
  

Inflation v Unemployment

Is inflation a lesser evil than unemployment?

Central Banks and governments often face a choice between reducing inflation or reducing unemployment. Which imposes the greatest cost on society - inflation or unemployment?

Firstly, it depends on the magnitude of inflation. If we are talking about hyperinflation (over 10,000% a year) then inflation can definitely devastate an economy leading to a breakdown in normal economic transactions. But, generally when we talk about high inflation in the UK / Europe, we mean an inflation rate of 5-20%. Off the top of my head, I believe the highest rate of inflation in UK since 1945 is around 27% in the 1970s.

It is also possible inflation is too low. Inflation or 0 or 1% would be most likely to cause economic stagnation. Some argue in climate where there is chance of deflation, we should target a higher rate of inflation (e.g. 3 or 4%)

Inflation imposes several costs on Society

• Inflationary growth is unsustainable. High inflation is often a sign the economy is overheating (demand growing faster than supply). This kind of boom is often followed by a bust (recession) This occurred in UK in Lawson boom of 1980s - inflation rose to 10% due to high growth and when the government tried to reign in inflation, it lead to the 1991 recession and higher unemployment. Therefore, an inflationary boom can lead to a recession. Targeting a low rate of inflation helps to keep economic growth sustainable. Therefore, low inflation can help avoid recession and prevent a sudden rise in unemployment.
• Inflation discourages investment. High and volatile rates of inflation can discourage firms from taking long-term investment decisions. This is because of the uncertainty and confusion around future revenues and profits. Therefore, it is argued countries with higher inflation rates tend to have lower growth rates over time. In the post war period, it was often argued Japan and Germany had better growth rates because of their low inflation.
• Decline in international competitiveness. High inflation is likely to make your goods and services less competitive leading to a fall in exports and current account deficit. Often this high inflation will be offset by a fall in the exchange rate to restore competitiveness. But, in the case of countries in the Euro, they can't devalue, so inflation and higher wage costs have been very damaging to their economy.
• Inflation can reduce real incomes. If inflation is above income growth, we can experience a fall in real incomes. This is an issue in 2011. High cost-push inflation of 5% is above wage growth leading to falling real wages.
• Inflation can erode savings. If inflation is higher than interest rates, then inflation can wipe away people's savings. Inflation reduces the value of money, so people who rely on income from savings see a reduction in their living standards. This is often a problem for pensioners who rely on savings. Therefore inflation can cause a redistribution of income in society from old to young and from savers to borrowers.
• Legacy of Inflation. If people suffer from inflation, (e.g. lose savings, become worse off) then it will impact their future decisions. For example, people may be reluctant to buy government bonds because they fear the government will effectively default through inflation. People will be more reluctant to save, leaving less room for investment.

See also: other costs of inflation

Economic Costs of Unemployment

Inflation definitely has economic costs, however arguably the costs of unemployment are far greater. Some of the costs of unemployment:

• Much lower income. The unemployed have to rely on unemployment benefits and they will see a drastic fall in income. Unemployment is one of the biggest causes of home repossessions (when you fail to keep up with mortgage payments) Losing your home is one of most traumatic events.
• Psychological costs. Unemployment is one of the biggest causes of stress. Without work, people feel a lack of purpose and low self-esteem. This can precipitate health and psychological problems.
• Social Problems. Unemployment can create a feeling of alienation from society. When you have a high unemployment rate amongst a particular group (region, ethnicity, age). feelings of social exclusion can be exacerbated. High unemployment rates are certainly one factor behind riots in cities in Spain, France and UK. It is not to excuse rioting, but if you have high unemployment and poor economic prospects it can only increase the risk of crime and vandalism.
• Higher Government Borrowing. A rise in unemployment leads to lower tax revenue (less income tax) and higher government spending on benefits. This may require lower spending elsewhere in economy.
• Negative Spiral. Higher unemployment will lead to lower spending in the economy leading to lower growth. The threat and fear of unemployment may be sufficient to reduce spending.

Which Has been the Biggest Cost To Society?

It is usually assumed inflation makes savers worse off. But, in the post war period, this hasn't occurred, interest rates have been higher than inflation meaning most savers don't lost out. They still get an interest rate higher than inflation. Even now with base rates at 0.5% and CPI close to 5%, their are still saving accounts with a respectable interest rate. Also the inflation is caused by temporary cost push factors and is likely to decline soon.

The economic and social costs of unemployment are far greater. However, it is not incompatible to have both low inflation and low unemployment. But, sometimes Central Banks (especially ECB) have made the mistake of focusing on reducing inflation at the expense of lower growth and higher unemployment.

Trade off Between Unemployment and Inflation

Related

• Is unemployment a price worth paying for lower inflation?
• Trade off between unemployment and inflation
• Economic growth v inflation
• Policies to reduce inflation and unemployment

Should We Blame The Bankers?

Last week I was in Manhatten, New York. I did think about going to visit the protesters on Wall Street, but preferred to sip cappuccinos in other suburbs of New York. I may not be an actual protester, but I can still be a 'coffee shop philosopher'. Are the protests against 'Wall Streets' greed, recklessness and selfishness justified? and can anything constructive come out of these popular demonstrations?

Essentially, we are experiencing a crisis due to failures amongst the financial elite. This crisis was caused by a combination of factor but foremost amongst this were mistakes, at least partly, driven by greed and arrogance.

If we look at the causes of the credit crunch. Top of the list would include:

• Encouraging selling of mortgages people couldn't afford
• Selling on risky assets to try and make them look safe.
• Failure to take appropriate steps to ensure stable banking.
• A pursuit of short term banking profit over long term sustainability.
• Failure of credit rating agencies to adequately reflect risk.
• Who is to blame for credit crisis?
  

For those uncomfortable with the idea the free market can fail, it is popular in America to blame the whole crisis on government mortgage agencies, even though they accounted for only very small % of bad sub-prime loans. But, the credit crisis of 2008 was essentially a failure of the free market and financial sector. To claim otherwise is to clutch at straws or engage in intellectual dishonesty. It was a failure of the financial system with both individual and corporate mistakes. There were too many willing to take risks and pursue profit at the expense of long-term prudence.

When the financial system ground to a halt. It was government intervention and the general taxpayers who stood in to solve the liquidity crisis. Governments did the right thing. If the taxpayer hadn't come to the rescue, we could have been facing a real depression.

But, there is a feeling financial institutions want the best of both worlds. When things go well, they advocate the free market, lower tax and the absence of government regulation. But, when things go badly, they anticipate state socialism to save them from their own mistakes. If an ordinary firm, had lost the billions financial firms did, there would have been no 'propping up of inefficient firms'. It is rather ironic that in the land of Capitalism, there was need for such state intervention in the most capitalistic of markets.

If your industry gets bailed out by the taxpayer, you can't complain if the taxpayer then starts asking questions such as why are you still getting so many bonuses? or Why do those living on investments, pay such a low rate of tax?

A few years after the credit crunch, little seems to have changed. The taxpayers got a raw deal for giving so much money. In America, there was not even the compensation of share ownership for all the money pumped into the financial system. There has been no fundamental change in regulation of the financial sector. Even very modest tax increases get scorned.

The past two decades have seen a rapid rise in inequality. The proceeds of economic growth have increasingly benefited the higher earners. Those at the lower end of the spectrum, have faced rising unemployment, stagnant incomes and increased pressure on living standards.

It is the case, that many of the wealthiest pay lower tax rates (e.g. capital gains 15%) than those on average incomes (35%). There is a feeling that the system is staked towards benefiting the richest, and they are right - it is. If there is any suggestion for increasing taxes on the rich, there is a media empire ready to shout how damaging to job creation it will be. But, the tax cuts for the high earners we have seen in the 80s, 90s and 2000s have not created the jobs or prosperity advocates would claim. Instead, the tax cuts saw the US with an increasing budget deficit in the boom years, leaving them less room for manoeuvre in the good years.

Alternatives

You can be very critical of capitalism and how it operates without being anti-capitalist. In the post war decade, the US and western Europe experienced rising economic prosperity and near full employment. The fruits of economic growth were shared across the income spectrum; it wasn't the preserve of the financial elite. The banking system worked relatively well. There was a focus on sustainable lending and encouraging saving to finance lending. This was a period of financial regulation and high tax rates. (The very tax rates critics argue would be devastating, were actually were complementary to a period of economic stability, growth and prosperity.)

Marx was wrong because he felt Capitalists would squeeze the workers until they wanted a revolution. Actually what happened is that capitalist paid higher wages to workers and workers were happy to be able to buy cars and goods. Who wants a revolution when you have a job and reasonable income?

Also as workers prospered, capitalists could sell even more goods and make more profit. Canny capitalists realised the better the average worker was, the better for them. Successful capitalism requires the spoils to be shared with a degree of fairness and equality. Reducing inequality in society, removing the scope for unnecessary financial risk taking, will not lead to stagnant growth - It would be good news for everyone, even those at the top.

Banks need to be regulated to prevent situations which encourage unnecessary risk taking.

Bash a Banker

It can soon become very crude to blame all societies ills on bankers. I could easily have been a banker myself; it doesn't make you a good or bad person. It is just at the present time, society enabled a system where the financial system was encouraged to take reckless risks which were guaranteed by the taxpayer. When it is good, the rewards were taken by the wealthy. When things were bad, it was shared amongst everyone. In the UK David Cameron famously said 'We're all in this together' - What he meant is we are all sharing the austerity together. But, in the good times, we were definitely not sharing all the proceeds of financial derivatives.

Conclusion

I'm happy to read about the protests. The financial system still needs reform to make it work for everyone, not just those at the top. There has been too much shift in wealth and influence to a privileged minority. At the present time, there is a great need to tackle unemployment; and in the longer term make the financial system work for society rather than society bailing out the bankers.

Related

• How Much Should we pay bankers?