Understanding Economics
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Introduction
For anyone living in the world, there is no escape from economics. Whether we like it or not, our lives are to some extent influenced by bond markets, quantitative easing and exchange rate markets.
Most of us have a vague idea about economics, but there can also appear several areas of confusion and paradox. Some things such as exchange rates and bond market seem to require a degree in accounting and finance to understand. With gaps in our knowledge, we often end up asking ourselves questions like:
• Why do government encourage people to save responsibly and then borrow astronomical sums themselves?
• Why do we have an inflation target, but no target for reducing unemployment?
• Why is it sometimes good to have a fall in the exchange rate, and at other times bad?
• Why do economists disagree so often?
If you are interested in finding answers to these kinds of questions, this book will hopefully explain some of the main issues in economics and how it affects our daily life.
One caveat worth mentioning -‐ when starting to learn about economics there can be a confusing array of new terms and ideas. It is hard to learn about one topic (e.g. government borrowing) without coming across related ideas on interest rates, and inflation. Therefore, in the beginning, it is fine not to understand everything. Just persevere and try to pick up one thing at a time. Later, you may look back and (hopefully) see how everything fits together. I always tell my students that the first two years are the worst. J
At the end of this e-‐book there is a list of economic terms which might be helpful for beginners.
-‐ Tejvan Pettinger, Oxford 2012
What do Economists actually do?
Some say economists make a lot of money from explaining why their economic forecasts didn't come true. Whilst this does have an element of truth, more seriously, economists try to understand how the economy is working. From observing what is happening, they can offer suggestions on how to improve the economy.
For example, an economist may try to work out what causes inflation. With this knowledge, they may be able to suggest what a government needs to do to keep inflation under control.
What is the Economy?
The economy refers to the process of producing and selling goods and services. The economy combines all the individuals and firms buying and selling goods. When you buy a snack in a shop you are participating in the total expenditure of the economy. If you work as a teacher or builder you are contributing to the output of the economy. When you receive wages from a firm, it is part of the national income of the economy.
From an individual perspective, we have many economic decisions to make. Should I do overtime? How should I travel to work? Should I increase my savings or spend more?
All these individual decisions contribute to the wider macro economy. For example, it might seem good sense to increase your personal saving, but if everyone increased his or her level of saving at the same time, it could cause a fall in consumer spending and lower aggregate demand; this fall in spending could cause lower economic growth and possibly a recession.
This is also known as the ‘paradox of thrift’. The paradox is that it may be a good idea for you to personally save, but if everyone increased their saving at the same time it could cause a problem.
This doesn’t mean saving is ‘bad’. Most economists say it would be better if the UK saved more. The problem occurs if we rapidly increase saving and reduce our spending when the economy is weak. But, this will be explained more later.
A Simple Model of an Economy
In a very simple model of the economy, we have:
1. Output. Firms produce goods and services. 2. Income. Wages / profit. Workers receive wages for producing goods.
Firms make profit from selling goods. 3. Expenditure. Workers use their wages to purchase goods.
From this simple model we may also add:
1. Imports and Exports. The UK trades with other countries (e.g. buying oil, selling financial services). This is measured by the balance of payments.
2. Government. The government raise money from various taxes and spend on various public services, such as transport and health care.
You could have an economy without the government -‐ perhaps on a desert island with a small group of people living in harmony. But, in developed society we need a degree of government intervention to regulate the economy.
Different Schools of Economics
There are different schools of economics which stress different beliefs and ideas. This is a brief summary of the main branches of economics.
Classical Economics / Free Market Economics
Classical economics stresses the role of the free market and are generally suspicious of government intervention in the economy. Free markets essentially mean the absence of government intervention, i.e. a free market allows private firms and consumers to decide what to produce and consume.
Adam Smith, in his influential book ‘Wealth of Nations’ suggested that a free market operated effectively without government intervention. Adam Smith observed that if people pursue their own ‘selfish interests’ it actually led to the benefit of everyone. For example, in the pursuit of profit, firms would provide the goods that consumers wanted to buy. Therefore in a free market there should be an efficient allocation of resources. This belief in free markets formed the basis of early or ‘classical’ economics.
Classical economics believe that the role of government should be limited to the protection of private property and perhaps regulating firms with monopoly power. But, essentially, they believe in little government intervention, low taxes and low government spending.
Laissez-‐faire Economics
Free-‐market economics is also referred to as ‘laissez-‐faire’ economics. -‐ The idea of allowing things to occur without government intervention. This belief in laissez-‐faire was very strong in the Victorian period. It is why the government refused to get involved in building of the nations railway lines. It is why many towns in the south of England had two train stations operated by two competing separate company. In laissez-‐faire economics, there is no role for a government welfare state. The Victorians feared a government safety net would encourage the poor to become ‘feckless’ and lazy.
Keynesian Economics
In the 1930s, the great depression seemed to show many flaws in the classical model. Free markets were not working efficiently -‐ there was mass unemployment that persisted for a long time. Keynes argued in this situation there was a greater need for government intervention to stimulate aggregate demand and overcome the recession.
Keynes advocated government borrowing to finance spending on public works and create economic growth. A basic tenant of Keynesianism is that the government needed to take responsibility for managing demand and economic
growth – and not leave it to the market as classical economists advocated. Note: Keynesian economics isn’t a justification for higher government spending per se. It emphasises the importance of increasing government spending in a recession.
Socialist / Marxist Economics
Socialist economics emphasises the inherent unfairness of capitalist society. Marxist theory suggests the means of production should be owned and managed by the state, and the state should run industries in the public interest rather than for profit. However, State Communism seemed to create a new class of bureaucrats and, due to a lack of incentives, firms had a tendency to be inefficient. There was a time in the 1930s, when the Soviet Union made rapid economic growth, despite state control. But, by the 1980s, Communist economies had fallen rapidly behind similar economies in the west.
Monetarist Economics
Monetarists share many similar beliefs to ‘classical economists’. They generally advocate lower levels of government intervention. Monetarists also have particular views on monetary and fiscal policy. Milton Friedman, a leading ‘Monetarist’, argued there was a strong link between the money supply and inflation. Therefore a monetarist would stress controlling the money supply as a means to controlling inflation. Monetarists are sceptical about fiscal policy (e.g. generally, they don’t believe higher government spending can help the economy). They argue higher government spending won’t increase real output, but just cause inflation.
Monetarism was tried in the UK between 1979-‐1984. The incoming Conservative government pledged to reduce inflation and control the money supply. To this end they pursued tight fiscal (higher taxes) and tight monetary policy (higher interest rates). They were successful in reducing inflation, but at the cost of a deep recession and high unemployment. Monetarism was effectively abandoned by 1984, as the link between inflation and the money supply proved to be very unreliable.
Austrian Economics
Austrian economics have a disdain for government intervention. In this sense they have similarities with classical economics in promoting free markets and discouraging government intervention in the economy. Austrian economics also argue that ‘fiat money’ money not backed by gold tends to devalue due to inflation. For example, Austrian economists would not support an expansion of the monetary base in a recession. Austrian economists would advocate going back to a gold standard (all money backed by actual gold reserves).
The Great Debate
In economics there is an on-‐going debate about the extent of government intervention in the economy. On the one hand ‘free market’ economists believe governments should concentrate on allowing capitalism to flourish. Keynesians argue the government needs to be more active, especially when the economy is in recession.
There is also a debate at the extent to which the government should intervene to deal with the inequalities created by a free market.
This economic debate is also mirrored by a political debate. Those on the ‘left’ tend to favour more government intervention to promote greater equality. Those on the ‘right’ feel it is more important to allow people to gain their rewards of hard work (i.e. inequality) and allow markets to operate freely.
In practise, there is no ‘simple ideology’ to explain different economic issues. Usually, economic issues involve a combination of different factors and ideas. I tend to be wary when someone claims they have a simple model which explains everything.
One Armed Economist To illustrate the reluctance of economists to commit to definite prescriptions, in the 1940s, the US President H. Truman exclaimed
‘Give me a one-‐handed economist’
He had got so fed up with economists always saying:
“well, we could do that, but on the other hand….”
Nevertheless, when starting to learn about economics, we do need to isolate certain variables and understand basic theories. Only when we have the basic idea behind theories can we learn when they are applicable and when we need to consider -‐ ‘but, on the other hand…’
Key Economic Issues
1. Economic growth and living standards 2. Recessions 3. Inflation 4. Unemployment 5. Government Spending / Tax 6. Government Borrowing 7. Balance of Payments 8. Interest Rates / Monetary Policy 9. Banking System 10. Exchange Rates 11. Euro 12. Globalisation 13. Free Trade 14. Disagreements of Economists 15. Frequently Asked Questions
1. Economic Growth
Economic growth means there is an increase in the size of the economy. It means more will be produced and people should be able to consume more goods and services. In theory, economic growth should lead to better living standards.
If you compare living standards now and 100 years ago, we have a very different level of wealth and income. The average person can consume much more. This is due to several decades of economic growth.
• Economic Growth is measured by changes in Real GDP, which shows the total value of goods and services produced.
• Real GDP means we take into account inflation. An increase in real GDP means there is actually more goods produced and not just more money in the economy.
• Typically, the UK economy grows on average by 2.5% a year. • However, the graph below shows economic growth can be quite volatile.
Economic growth in UK – showing deep recession of 2008-‐09.
Why is Economic Growth Important?
Most governments target higher economic growth. Higher economic growth has various benefits for the economy.
1. Higher wages. Increased real GDP means we can have higher incomes and purchase more goods and services
2. Helps reduce unemployment. If there is economic growth, firms will be expanding and taking on more workers, this helps to reduce unemployment.
3. The Government receive more tax. If we have economic growth and higher incomes then the government will get more tax revenue – even though tax rates stay the same (e.g. basic rate of income tax of 23%). This enables the government to increase spending on public services like health care and education.
4. Reduces the Government’s debt burden. Most people assume that government borrowing leads to higher tax rates in the future. But, if there is economic growth, then we can use the higher tax receipts to reduce the ratio of debt to GDP, without increasing tax rates.
5. Improved public services. With higher national income, we should in theory be able to spend more on welfare policies which help to reduce poverty and provide better living standards.
Are there any problems With Economic Growth?
• Inflation. If economic growth is too fast, demand for goods may be increasing faster than UK firms can produce them. Therefore, firms respond by putting up prices, which causes inflation.
• Boom and Bust Cycle. If economic growth is too fast it tends to be unsustainable. This can lead to a boom and bust cycle. This occurs when growth is very high, but is followed by a slump (negative economic growth). In the 1980s, the UK experienced a boom, with rapid economic growth of over 5% a year. However, this rate of growth proved unsustainable, leading to inflation and later the recession of 1991-‐92.
• Environmental Costs. Higher economic growth usually leads to greater use of raw materials and pollution. Therefore although we may have higher output, living standards may not actually increase.
Link Between Inflation and Economic Growth
In theory, higher economic growth causes higher inflation.
• For example, during a period of strong economic growth in the 1980s, we can see a rise in the rate of inflation. Attempts to reduce this high inflation led to the recession of 1991.
Link Between Economic Growth and Inflation in US
• This shows there is a rough trade off between inflation and unemployment.
• For example, in 1979, inflation falls from 14% to 2%, but during this period, unemployment rises from 7% to 11%.
• At the start of 2008, inflation drops sharply (a rare period of deflation in 2009) and unemployment again rises.
• This shows there is often a trade off between inflation and unemployment.
Q. Why Does it Feel Like Prices Go up in a Recession?
• Typically, lower economic growth leads to lower inflation. However, it is also possible for inflation to increase at the same time as negative economic growth.
• For example, a rapid rise in oil prices (e.g. 1974, 2008, 2011) leads to a squeeze on living standards. Prices rise quicker than nominal wages, leading to lower consumers spending and lower economic growth, but also higher prices (termed cost-‐push inflation.)
Happiness Index
Some critics of economics argue that too much emphasis is placed on increasing income and wealth. They argue this focus on economic growth ignores more important factors that influence living standards, such as the environment, education and health care.
You could ask -‐ are we happier than 30 years ago?
GDP is certainly much higher than 30 years ago. But:
• There is more crime • There is greater congestion on our roads. • There is a shortage of affordable housing. • Arguably stress and dissatisfaction levels are just as high. • The environment is a cause for concern with issues such as depletion of
rain forests and global warming. • People are working longer hours, leaving less time for leisure. • There has been a growth in obesity and cancer levels.
This shows the limitation of economic statistics. Economic growth has potential benefits, but there is much more to life than higher real GDP. To improve living standards, we need to consider much more than simple statistics on wealth and income.
If you are old enough, you might remember the BBC Sitcom – The Good Life. A couple in Surbiton gave up their jobs in the city to be self-‐sufficient in their Surbiton back garden. From an economic point of view, their income fell drastically, but this ‘good life’ could give more happiness than working all day in a boring 9-‐5 job.
However, although we may like to complain about modern life, it is hard to argue we would be better off over 120 years ago with the Victorian slums. Economic growth has enabled a significant increase in living standards. Generally people are able to avoid absolute poverty (not enough money for basic necessities). This kind of poverty did occur in the nineteenth century, but has largely been abolished thanks to prolonged economic growth, which has helped increase living standards.
In the post war period, we have also been able to afford a national health care service and universal welfare benefits, which has helped to reduce inequality.
Economic growth has benefits, but also it has limitations. It is not a cure for all ills. Economics growth definitely makes it easier to tackle certain issues, but can also create its own problems.
What Affects the Rate of Economic Growth?
Economic growth requires two things:
1. Increased demand (consumer spending, government spending, export demand, and investment spending)
2. Increased supply / increased productive capacity.
• If we have higher demand, but firms can’t increase supply, then consumers will be frustrated and there will be inflation rather than economic growth.
• Similarly, it is no good producing more goods if the demand isn’t there. There will just be unsold goods and spare capacity.
Demand in the economy can increase if:
1. Consumers have higher wages and want to spend it. 2. Demand for exports from abroad, e.g. countries like China, Japan and
Germany rely on selling exports. 3. Lower interest rates. Lower interest rates increase household disposable
income (e.g. lower mortgage interest payments) encouraging people to spend.
4. Confidence. If people are confident about the future they are more likely to borrow and spend rather than save.
5. Rising wealth. Rising house prices gives householders greater confidence to spend. Rising house prices also enable firms to re-‐mortgage and gain equity withdrawal.
6. Firms invest creating more employment and demand for capital. 7. Increased government spending, e.g. higher wages for public sector
workers.
Aggregate Supply can increase if:
1. Firms expand production, e.g. invest in building new factories 2. Workers become more productive (higher output per worker). For
example, if workers learn new skills or become more motivated to work hard.
3. Better communication and transport links. 4. Growth in population, e.g. immigration, especially if new workers are
skilled in areas of job shortages. 5. Improvements in technology, e.g. Internet and microcomputers make the
economy more productive.
Question: Why has China been able to manage economic growth of nearly 10% a year since the 1980s?
For nearly three decades, the Chinese economy has been able to expand at a breakneck pace, catching up with developed economies in the West. China’s growth has averaged close to 10%; this is much higher than the UK’s growth rate, which has averaged 2.5% in the same period.
Reasons for the rapid rate of economic growth in China include:
1. Potential efficiency gains from privatising state owned industries. For many years, China was a centrally planned Communist economy. Many state owned industries were highly inefficient (because workers had a lack of incentives and there was overstaffing). Many of these industries have been privatised and this has enabled leaps in productivity and efficiency (e.g. sacking surplus workers)
2. Shift from Agricultural sector to manufacturing. China had a large proportion of workers in agriculture. Small, inefficient farms meant that farm workers contributed very little to output. The growth of the manufacturing sector has enabled much greater output than in the agricultural sector.
3. Low Wage Costs. China has millions of workers willing to move to the manufacturing sector at relatively low global wages. This has meant that, despite the growth of the export sector, manufacturing wages have remained low, giving China a continued competitive advantage.
4. Globalisation and Comparative Advantage in Exports. China’s growth has been largely based on exports. The process of globalisation has helped create a large global market for China’s exports.
5. Weak Chinese Currency. A factor that has contributed to China’s growth is the relative weakness of the Chinese currency – the Yuan. China has deliberately kept the currency undervalued to make its exports more competitive. This isn’t the main reason for economic growth in China, but it has helped provide an extra boost to export demand.
At this stage in China’s economic development, there is more potential for rapid growth. It would be much harder for the UK to experience such rapid growth in productivity and productive capacity, because the economy is already more developed and there isn’t the same scope for efficiency gains.
Global Inequality
There is huge inequality between nations, which can be illustrated by Real GDP per capita statistics.
• Real GDP per Capita. – This means the average income per person in the country.
How Does the UK compare to other countries?
According to the IMF (2010) the UK is ranked 22nd in terms of GDP per Capita.
Selected countries:
• Luxembourg $108,832 (1st) • United States $47,284 (9th) • France $41,019 (18th) • United Kingdom $36,120 (22nd) • Ethiopia $350 (178th) • Congo, Democratic Republic $186 (182th)
This shows a huge disparity in average incomes. A person in Luxemburg is likely to have an income nearly 50 times greater than the Congo.
Reasons for Inequality
To some extent, statistics don’t tell the full story.
• There is a cheaper cost of living in poor countries. It will be much cheaper to rent accommodation in Congo than a developed country. Therefore they are not strictly comparable. An annual income of $350 wouldn’t last a week in Luxembourg, but goes much further in the Congo.
• Subsistence Living. In very poor developing economies, people may live as subsistence farmers. Growing their own food, they may receive no cash payments. Therefore, according to GDP statistics they have zero income, but a subsistence farmer could have a reasonable living standard if food is plentiful.
These factors reduce effective inequality, to some degree, but, despite this, there is also still a vast gulf in living standards between different parts of the world. This has a profound impact on living standards across the world. Countries with higher real GDP per capita tend to have greater life expectancy, higher rates of literacy and provision of social services.
Reasons for Gulf in Living Standards across the Globe
• Different levels of economic development. For example, the UK economy went through process of industrialisation in the nineteenth century; some developing economies are still largely agrarian.
• Development held back by corruption / civil war. Often war, corruption and political uncertainty can be a key factor in discouraging economic development.
• Regional Effect. Countries in Europe tend to benefit from the strength of other European economies. Countries in Sub-‐Saharan Africa are constrained by low levels of economic development in neighbouring countries.
Why are The Poorest Countries often the Richest in terms of Raw Commodities?
It is a paradox that countries like Germany and Japan are relatively poor in terms of raw materials (Japan has to import most of its raw materials). Yet, some African countries with an abundance of diamonds, oil and gold are among the poorest.
• Owning raw materials is not a guarantee of wealth. Foreign multinationals or a small number of local owners can siphon off profits from gold and diamonds. In this case, most workers may see little benefits from the raw materials.
• It also shows how international trade enables countries to benefit from adding value to raw materials and selling at a profit. Japan and Germany have excelled at adding value to manufactured goods.
• Substantial raw material reserves can help boost living standards, but much more is needed, such as infrastructure and a developed economy.
• It is also important how equitably resources are distributed throughout the economy.
2. Recession
A recession means we have negative economic growth. It means the economy is becoming smaller in size. (The technical definition of a recession is a period of negative economic growth for two consecutive quarters (6 months). During a recession:
• Consumers will be buying fewer goods – especially luxury goods like sports cars.
• Firms will cut back on production. Some firms may go out of business because they are not selling enough.
• Unemployment will rise. As firms cut back on production they need less workers.
• Low inflation. Firms have unsold goods so typically cut prices to try and sell more. In some cases, this may lead to deflation.
• Government borrowing increases. Governments will receive lower income tax and lower VAT receipts. However, they have to spend more on unemployment benefits. Therefore in a recession, government borrowing automatically tends to rise.
• Saving increases. In a recession, people are nervous about spending and borrowing; instead people tend to increase their level of savings.
• Exchange rate is likely to become weaker as interest rates in the country will be low.
What Causes Recessions?
A recession can be caused by a variety of factors that lead to lower spending and demand in the economy.
1. Higher interest Rates. In 1991 interest rates were increased to 15%. This made mortgages very expensive, leaving households with little income left over to spend. This caused a fall in consumer spending and negative economic growth.
2. Appreciation in the Exchange Rate. In 1979-‐80, the UK experienced a rapid rise in the value of the Pound. This made UK exports uncompetitive, leading to a sharp fall in demand for exports and a decline in the manufacturing sector (manufacturing output fell 30% during this period). The strong exchange rate also occurred during a time of higher interest rates and policies to reduce inflation.
3. Credit Crunch. In 2007, banks lost a lot of money and struggled to maintain their liquidity; therefore, they had to cut back on lending to firms and consumers. It became very difficult to get a loan or mortgage from a bank; this led to a fall in spending and business investment.
4. Confidence. If consumers and firms become worried about the future, they will spend less and save more – causing a fall in overall demand. Therefore, if
people fear a recession, it can become self-‐fulfilling. (There is a saying that you can ‘talk yourself into a recession’)
There can also be a bandwagon effect. When the recession starts and unemployment rises, this causes a fall in income for the unemployed; this causes a bigger fall in confidence and even bigger fall in output.
• For example, the Wall Street Crash of 1929 caused a loss of confidence in the stock market and financial markets. This was a significant factor (though not the only one) that caused the Great Depression of the 1930s
• After 9/11 there was a fall in confidence in the US economy. The government and Federal Reserve responded very quickly to try and maintain economic growth.
• Falling house prices tend to reduce confidence too.
5. Rising Oil Prices. Rapidly rising oil prices could cause a recession. In the 1970s, the oil price almost tripled, this was a real shock to western economies that were reliant on cheap oil. The rise in oil prices reduced disposable income and led to lower spending and a short-‐lived recession of 1974.
6. Global Recession. In the global economy, it is hard to remain unaffected by the situation in other countries. If other countries enter recession, there will be a fall in demand for UK exports; there will also be a fall in confidence leading to lower growth. Also the banking system is very global. If banks lose money in America, it tends to reduce lending by UK banks
7. Falling Asset Prices. If there is a rapid fall in house prices, this tends to reduce consumer spending as householders see a decline in wealth. Falling asset prices also lead to higher bank losses making banks reduce their lending. Falling asset prices were closely linked with the credit crunch in 2007-‐09. Falling asset prices can be prolonged and it can be harder to recover from this kind of recession.
Paradox of Thrift
'Paradox of thrift; is a concept that if individuals decide to increase their private saving rates, it can lead to a fall in general consumption and lower output.
Therefore, although it might make sense for an individual to save more, a rapid rise in national private savings can harm economic activity and be damaging to the overall economy.
In a recession, we often see this 'paradox of thrift'. Faced with prospect of recession and unemployment, people take the reasonable step to increase their personal saving and cut back on spending. However, this fall in consumer spending leads to a decrease in aggregate demand and therefore lower economic growth.
Paradox of Thrift in 1930s
In the great depression of the 1930s, GDP fell; unemployment rose and the UK experienced a long period of deflation. In response to this disastrous economic situation, mainstream economists were at a loss as how to respond. Such a lengthy period of disequilibrium didn’t sit well with Classical theory, which expected markets to operate smoothly and efficiently.
One policy the National government did approve was the cutting of unemployment benefits. The rationale was that in times of a depression the government should set an example by reducing its debt. This example actually inspired members of the public to send in their savings in the hope that it would help the economy.
By reducing benefits they further reduced consumer spending and overall demand. This made areas of high unemployment even more impoverished. When people saved rather than spent their money it just made the recession worse.
J.M. Keynes argued that this 'paradox of thrift' was pushing the economy into a prolonged recession. He argued that in response to higher private saving, the government should borrow from the private sector and inject money into the economy.
This government borrowing wouldn't cause crowding out because the private sector were not investing, but just saving.
In the UK and US, Keynes was largely ignored until the outbreak of war. For much of the 1930s, the UK economy experienced high levels of unemployment.
Can Governments Prevent Recessions?
In theory, governments can prevent recessions. In practise it can be difficult.
1. Demand Side Policies. If the government expect a recession due to falling private sector demand. They can pursue expansionary fiscal policy (higher government spending / lower tax). This expansionary fiscal policy requires higher government borrowing. But, the governments borrowing should help to offset the rise in private sector saving. These injections of spending could kick-‐start the economy and create demand and jobs. If the government does nothing, the recession may persist for a long time. However, in a recession, it may be difficult for the government to borrow more (e.g. Eurozone economies faced great difficulties with borrowing more in the 2008-‐11 recession.)
2. Prevent Boom and Bust Cycles. With the help of the Central Bank, the government can try and prevent boom and bust economic cycles. This is why they target low inflation and economic growth that is sustainable. If inflation remains low and growth sustainable, there doesn’t have to be a rapid increase in interest rates, which can cause a recession.
3. Prevent Asset Bubbles They can avoid boom and bust in lending and asset markets. In theory, the government could introduce regulation to
prevent property bubbles and a boom in bank lending which becomes unstable. In practise this is easier said than done. Governments and Central Banks may not be able to spot asset bubbles (or they ignore the evidence). Also, some argue it is hard to regulate bank lending because they can find ways around it.
4. Bailout Banks. If banks go bust, it can destroy confidence in the financial market and lead to a decline in the money supply. In 1932, over 500 US banks went bankrupt; this made the Great Depression worse. Therefore bailing out banks can be in the public interest because it prevents a collapse in confidence in the financial sector. However, there is a real problem that it can encourage banks to take risky behaviour because they know the government will have to bail them out.
5. Central Bank Intervention. To help prevent recession, a Central Bank could cut interest rates, and if necessary increase the money supply through quantitative easing. Lower interest rates give borrowers more disposable income and so encourage spending in the economy.
Real Business Cycle
Some economists (Real Business Cycle) argue the government can’t prevent recessions and they should just allow them to run their course. They argue government intervention often just makes the situation worse. The real business cycle theory argues that recessions are caused by technological changes and supply side factors, therefore demand plays little role. Therefore, according to the real business cycle theory there is inevitability about recessions. Some economists even go as far to say recessions are beneficial. The argument is that in a recession, inefficient firms go out of business, and there are greater incentives for firms to cut costs and be more efficient. Some famous firms like General Motors and Disney started during a deep recession.
However, other economists argue this ignores the strong empirical evidence showing that recessions are caused by a drop in private sector spending, and that recessions can be avoided.
Also, it is very controversial to argue recessions are ‘beneficial’. In a recession there is often long-‐term economic damage, such as:
• Rise in long-‐term unemployment (unemployed find it difficult to get back into work)
• Some good, efficient firms may go out of business just because of a temporary lack of demand.
• Investment will fall sharply in a recession, causing lower productive capacity in the future.
3. Unemployment
Unemployment occurs when a worker who is able and willing to work, is unable to find a job.
Prolonged periods of unemployment can be the most stressful experience for a person. Yet across the European Union, unemployment rates have been persistently high, averaging close to 10%
For example, in 2011, Spain had an unemployment rate of 21%; amongst young workers it was as high as 45%.
What Causes Unemployment?
1. Recession. The biggest cause of unemployment is due to the state of the economy. If output falls and we enter a recession, firms will lay off workers or firms will go bankrupt completely. Therefore demand for workers falls.
The above diagram shows the link between economic growth and unemployment. When the economy contracts, unemployment rises. The worst period for unemployment in the UK was in the 1930s during the Great Depression. In this period unemployment reaching 12% +. In some industrial areas it was as high as 40%.
But negative economic growth isn’t the only cause of unemployment. Even during times of strong economic growth, we can still have unemployment. What causes unemployment in these situations?
1. Unskilled Workers. Often there are job vacancies, but the unemployed may lack the skills and qualifications to take a job. An unemployed coal miner may like to work as a nurse or computer technician, but he doesn’t have any relevant skills to accept the job.
2. Voluntary Unemployment. The argument is that if unemployment benefits are generous, then people may lack the incentive to take a job at a low wage rate. Often if people get a job they have to pay higher taxes and lose several benefits such as unemployment benefit and housing benefit, therefore there may be little financial incentive to take a job. It is worth pointing out that in the UK the gap between unemployment benefits and wages has grown in recent years. Voluntary unemployment is often a controversial concept.
3. Wages Too High. Arguably trades unions and minimum wages can make labour too expensive. A hairdresser may complain that they could employ workers at £4 an hour, but the minimum wage of £5.89 is too high. Therefore minimum wages and trades unions can cause unemployment. However, there have been periods of time when increasing the minimum wage also leads to lower unemployment. (1997-‐2007)
4. Geographical Unemployment. Another feature of unemployment is that it is highly localised. There may be many unfilled vacancies in Central London, but in the North East, unemployment may be very high. In theory an unemployed worker could move south, but in practise it may be difficult to get accommodation in Central London and find a new school for their children.
5. Takes Time To Find Work. Not all unemployment is long term; often people are unemployed for a short period -‐ in between jobs. This is known as frictional unemployment
6. Tight Regulation. It is argued that in the EU, there are generous laws and protection for workers. For example, it is difficult to fire workers and there are restrictive practises like maximum working weeks and statutory pay. This is good for workers with jobs, but the costs involved in employing labour arguably deter firms from investing and hiring workers in the first place.
Question: Does Labour Saving Technology cause Unemployment?
Ever since the Luddites went around smashing machines in Nineteenth Century Britain, there has been a strong fear that labour saving technology can cause unemployment. To some extent it is true. If a firm finds a machine that can do the job of 10 workers, then they may be able to get rid of these surplus workers causing some temporary unemployment. If these workers lack skills and geographical mobility, they may find it difficult to find new unemployment.
However, labour saving technology tends to create as much employment as unemployment.
• Firstly, there will be new jobs created in making the machine.
• Secondly, the labour saving technology helps reduce costs and prices of goods. Therefore, overall consumers have more disposable income to spend on other goods and services. Therefore other industries in the economy tend to benefit from higher growth leading to more job creation.
200 years ago, 90% of the British workforce were working in agriculture. However, over time, new machines meant that farms needed fewer workers and so people lost jobs on the farm. But, as the economy devoted fewer resources to agriculture, new jobs in manufacturing were created.
As manufacturing became more efficient, a smaller workforce was needed. This enabled a growth in the service sector. – Jobs which can’t be done by machines like doctors, teaching and waiters.
Technological change can cause temporary unemployment, especially if the change is rapid. It can be a problem if it is concentrated in a certain regions (e.g. old coal mines). However, technological change has enabled a different economy and workers are able to do less manual labour and more service sector based jobs.
It makes no sense to stop technological change to protect jobs, however it may make a lot of sense to help the unemployed develop new skills to find new jobs in new industries.
How Can A Government Reduce Unemployment?
1. Promote economic growth. In a recession, the government and central bank will need to try and increase demand. This may require government borrowing. In the great depression, Keynes advocated an expansion in government spending to try and stimulate economic growth and create jobs.
2. Labour Market Flexibility. A popular buzzword among free market economists. Labour market flexibility means reducing levels of regulation and the cost of hiring workers. The hope is that less regulation encourages firms to employ more workers in the first place.
3. Retrain Workers. Workers who have been unemployed for a long time, may need to learn new skills and be given more motivation to keep looking for a job.
4. Lower Benefits. It is argued reducing unemployment benefits increases the incentive for the unemployed to get a job. However, in the UK benefits are already quite low compared to wages.
Q. Why do we have an inflation target (2%) but no unemployment target?
It often seems Central Banks are concerned about keeping inflation low, but not so concerned about reducing unemployment.
The argument is that low and stable inflation provides the best framework for sustainable economic growth. This low inflation and economic growth will help job creation in the long term.
If you target low unemployment, it may cause a boom, which temporarily reduces unemployment, but also causes inflation and the economic growth will be unsustainable. Therefore it is better to target low inflation and gradually reduce unemployment.
Also, if unemployment is structural (lack of skills), the solution is not to increase demand (lower interest rates) but supply side polices (e.g. education and training) and these are long-‐term solutions.
However, you could argue Central Banks do worry too much about inflation and don’t give enough importance to reducing unemployment. For example, a rise in cost-‐push inflation is usually temporary. To stick to an inflation target, when there is an oil price shock may cause a recession and higher unemployment.
Some economists argue for a higher inflation target to give Central Banks more room for manoeuvre to achieve full employment.
4. Inflation
• Inflation basically means prices in the economy are increasing. • The inflation rate measures the annual % increase in prices.
Inflation is something we can all relate to as usually we see our cost of living increasing each year.
Graph showing different rates of inflation in UK
My grandma would often exclaim how expensive things were ‘these days’. In ‘her day’, you could get a loaf of bread, pint of beer, train ride home and still have change from sixpence. Now, to buy these three goods, you wouldn’t get much change from a £10 note. This is an example of how inflation increases prices over a long period of time.
Inflation reduces the value of money. If prices go up, it means a £10 note buys less in 2011 than it does in 1940. Therefore inflation will reduce the value of money. This is why in a period of high inflation, it isn’t good to keep your cash under your mattress. – the money will soon become worthless.
Q. Is Inflation a hidden tax on the middle classes?
Inflation can definitely erode the value of savings. If you have cash holdings, then inflation will reduce its value.
Also, people may buy government bonds, but inflation will reduce the value of these bonds, making it easier for the government to pay back its debt. It will mean that savers who buy government bonds lose the value of their savings.
Real Interest Rates
A key factor is -‐ what is the interest rate?
• If inflation is 7% but interest rates 9%, then savers won’t be losing money if they save in a bank.
• Although inflation reduces the value of money, the higher interest rates offsets the effects of inflation.
If markets fear a government will ‘inflate away its debt’ then markets will demand a higher interest rate on government bonds to compensate for the risk of inflation reducing value of bonds.
In the post war period, real interest rates were generally positive. This meant that savers were not adversely affected by inflation. (Unless they just kept cash under their mattress)
Inflation is a real problem, when the inflation rate is higher than any saving interest rate.
Deflation
In a few occasions in the twentieth century, the UK has had a negative inflation rate. This means prices were actually falling. This has been very rare post 1945. However, it did occur during the 1920s and great depression of the 1930s. Falling prices are known as deflation.
CPI – Consumer Price Index
Every month we get a new official inflation figure. For example, CPI = 4.5%. This means the average price of goods and services increased by 4.5% in the past 12 months.
RPI – Retail Price Index.
The RPI is similar to CPI, however it includes mortgage interest payments. Therefore, if MPC increased interest rates, the RPI would increase at a higher rate than CPI. There are a few other minor differences between RPI and CPI. RPI tends to be higher than CPI.
How is Inflation Measured?
1. Give a weighting to goods (how significant it is) 2. Measure price changes of most commonly bought goods every month. 3. Multiply price change * weighting of good.
The Family Expenditure Survey looks at people’s spending habits to find the most commonly bought ‘basket of goods’. To get an accurate overall inflation figure, we need to know how significant a good is. If salt increases in price it will have much less impact on overall inflation than if petrol increases in price.
This basket of goods is always changing. In the 1940s, it included items like Spam, LP records and Stout. Today’s basket is radically different with new items like iPads and mobile phones included. Some goods are still there, such as bread and milk etc. but this typical basket of goods is being constantly updated to reflect changes in spending patterns.
Secondly, the ONS check prices of goods every month and multiply the price change by the weighting (how important it is) of the good.
Understanding Inflation Data
What does this graph show?
• This graph shows the rate of inflation between 1989 to 2010. It shows that prices were always increasing during this period.
• In 1990, prices were increasing by 9% a year (end of Lawson boom) • In 2000, prices were increasing by only 1% a year • In 2008, prices increased by 5% (due to rising oil prices) • In 2009, inflation fell and prices increased by only 1.5% (due to
recession)
Question: What happened to prices between 1990 and 1994?
• The correct answer is that prices increased at a slower rate. The inflation rate fell, but prices still went up (albeit at a slower rate).
• (It is tempting to see the graph and say prices fell. But, it is just the rate of increase that fell.)
Why Does Inflation feels higher than the official figure?
Often people feel that inflation is higher than the government’s official figure. For example, we may have inflation of 4.5%, but we see petrol prices have increased 15%, food 7%, and heating 12%. It can feel inflation is under-‐estimated.
Firstly, different goods and services don’t increase at the same rate; they can often be quite different. For example, while petrol prices may rise 15%, the cost of telephone calls may be falling 7% and price of computers may be falling 11%.
If you spend a high % of your income on heating, fuel and food, in this case your own personal inflation rate may actually be higher than the national average. This is because the goods you buy are increasing faster than the average. If you are a pensioner, you may not benefit from the falling price of computers, but you do have to pay more for heating. Therefore, the average inflation rate may be 4.5%, but for some people their cost of living is actually increasing faster than this 'headline rate'.
This means some people who see their pension increase in line with inflation may actually be coming worse off.
Psychology of Inflation
Another issue is that rising petrol prices can make front-‐page news, but when they fall -‐ it doesn’t. We notice price rises more than price falls.
Some goods like petrol, food and fuel are more volatile. Food prices can fluctuate due to the weather. Sometimes, we can see a big increase in food prices and next month they fall. However, it is the price rises that stick in the mind more than the price falls.
The psychology of inflation may also depend on our living standards. If our wages are rising, then the price rises are affordable. But, it times of weak wage growth, any price rise feels more painful.
Question: Why are there several measures of Inflation?
We started with the simple definition of inflation; inflation is an increase in average prices. This is quite straightforward, however it depends what we decide to include in the basket of goods. It depends which prices we measure.
We have many different measures of inflation, including, CPI, RPI, RPIX, CPI-‐T, HCPI (and many more)
Firstly, I would say don’t worry; even some economists would struggle to name and define all these innumerable measures of inflation. But, they are all based on the same principle. They just include or exclude different factors.
• RPI includes the cost of mortgage interest rate payments. • CPI – T excludes the temporary effect of increasing excise duty tax.
In 2011, the government increased VAT. This means prices increased because of the higher VAT. However, this increase in prices is a one-‐off increase. Therefore, in the next year, the inflation won’t include this tax increase. Therefore, it is useful to look at CPI-‐T, which excludes the temporary effect of taxes.
Core inflation
One useful concept is the idea of ‘core inflation’. This is the inflation rate that excludes volatile and temporary factors. For example, core inflation excludes one-‐off tax increases, petrol and food.
This is important because if we get a rise in volatile prices (commodities and oil) it may just prove to be temporary.
For example, in 2008, inflation rose to 5% due to rising oil prices. But, 12 months later inflation had fallen to less than 1% due to the recession. In other words, the oil price ‘spike’ proved to be temporary. We can say underlying inflation was low.
Underlying or core inflation depends primarily on the strength of demand in the economy. A good guide to core inflation is wage inflation. If wage inflation is muted, core inflation is likely to be low too.
Chain Weighted Index
Another problem with measuring inflation is that changes in prices may alter our spending patterns. Suppose there are two goods we like to buy -‐ bus tickets and train tickets. An increase in train tickets may cause inflation to increase. But, the higher price of train tickets may mean we stop using the train and just use the bus. Therefore, we are actually not affected by higher train fares. A chain weighted index takes into account these changed spending patterns resulting from higher prices.
Example of Different Inflation Rates
This graph shows how some goods tend to be quite volatile. Electricity and Gas both shows a very rapid inflation in 2008 before falling in 2009.
Note: the price of communication has often been falling. This is due to technological gains.
If a person spent a high % of income on electricity and gas, they would have a higher personal inflation rate, than if they spent a high proportion of income on communication.
Q. Do governments not just choose the most convenient inflation rate?
As the saying goes there are lies, damned lies and statistics. By choosing your inflation rate, it can give a quite different impression of the economy. One issue is that benefits are often ‘index linked’. This means that benefits and pensions are increased in line with inflation. However, RPI inflation could be 6%, CPI 4%, and CPI-‐T 2.5%. Therefore, it is very important which measure is used to set benefits.
Importance of Core Inflation
For the Bank of England it is important to know whether inflation is likely to be just temporary or permanent. Therefore, looking at ‘core inflation’ can be useful. For example, in 2011, we had a spike in inflation due to cost-‐push factors. Usually this rise in inflation to 5% would cause the Bank to increase interest rates to reduce demand and economic growth. However, in 2011, the economy was heading towards a double dip recession, and the Bank felt that the inflation was due to temporary factors (higher tax, higher import prices, higher oil prices) therefore, they could leave interest rates unchanged because core inflation was low.
Reasons Why Inflation May be Under-‐estimated
1. People are buying new goods and services, which are increasing in price, but not included in the basket of goods. (e.g. new popular iPhone App)
2. Some people may have a higher personal inflation rate, because they spend a higher % of their income on gas and energy, which can rise faster than the average inflation rate.
Reasons Why Inflation May be Over-‐estimated
1. Goods increase in price, but the price increase is because of improved quality. If a new version of mobile phone is more expensive, is this inflation or a reflection of improved product quality?
2. When goods increase in price, people switch to alternatives and stop buying the expensive goods. Therefore, they are less affected by rising prices.
Hyper-‐inflation
Hyperinflation occurs when the inflation rate is very high. (Over 1000%). This means that prices are rising so rapidly it destabilises the economy.
A well-‐documented case is Germany in the 1920s. Inflation was so high that the price of goods would go up almost every hour. If you got paid in the morning, you had to buy goods straight away because in the evening, your wages couldn’t buy anything.
When inflation is this high, money can become worthless and people resort to a barter economy (barter economy means pay with physical goods, e.g. if you have hens you could use eggs to buy a train ticket. As you can imagine, this makes life pretty difficult).
An apocryphal story in 1920s Germany is that people needed so much money they had to carry it around in wheelbarrows. When left outside a shop, the money was often left, but someone stole the wheelbarrow because it was more valuable than the 1,000,000,000 marks.
One reason economists fear inflation is that if inflation becomes embedded and takes off, it can lead to hyperinflation and economic instability as people lose faith in the monetary system.
Why is Inflation Harmful?
It makes sense that an inflation rate of 1,000,000% is a real pain, but some economists get very worried if inflation starts to increase above 2%. Why is even moderate inflation considered harmful?
1. Uncertainty and Confusion. The argument is that if inflation is high, firms may be discouraged from investing because they are uncertain about future prices and costs. Low inflation creates greater certainty in the economy. It is argued countries with low inflation tend to have better economic performance in the long-‐run.
2. Lower international competitiveness. If UK inflation is higher than our competitors, it means UK exports will become less competitive leading to lower demand and lower growth in the UK.
3. Lack of Control. There is a fear that a small rise in inflation could cause an upward spiral and inflation getting out of control. For example, in the 1970s, higher oil prices pushed up inflation; this led to higher wages and a wage price spiral that was hard to contain.
4. Unsustainable Economic growth. Economists would rather have stable sustainable growth and low inflation. If the economy grows too quickly and firms push up prices, this growth can lead to a boom and bust economic cycle. (High growth followed by recession, e.g. Lawson Boom)
5. Fall in Living standards. If people have fixed incomes or savings in cash, inflation reduces the value of money and makes them worse off. This is why some people say inflation is like taxation without regulation. Inflation reduces the value of your savings. However, it depends on the real interest rate. If interest rates are higher than inflation, then you can protect your savings.
Deflation
Deflation occurs when prices fall. It means a negative inflation rate (e.g. CPI -‐0.5%)
If Inflation is bad does that mean deflation is good?
Unfortunately, deflation can often create serious problems for the economy. In fact economists joke (if we can call it a joke) that the only thing worse than inflation is deflation.
The UK experienced deflation in the 1920s and 1930s (great depression). This period of deflation was associated with falling output and high unemployment.
Deflation in the UK during the 1920s and 1930s was a period of high unemployment and low growth.
The post war boom of 1945 to mid 1970s was a period of moderate inflation.
Problems of Deflation
1. Lower spending. When prices fall, people delay buying goods (they wait for it to be cheaper next year, especially for expensive luxury goods). Therefore, this delay in consumer spending leads to lower demand in the economy and this can lead to a fall in output and higher unemployment. For example, Japan experienced deflation in the 1990s and 2000s, and it created an unwillingness to buy goods and lead to a prolonged period of low economic growth. (This may sound counter-‐intuitive because if an individual good is cheaper, we will buy more. However, when the price of all goods are falling, we find people often spend less – preferring to wait)
2. Increase real value of debt. Falling prices means our debt is harder to pay. Most people have some kind of debt, e.g. mortgage, credit card debt. Deflation increases the real value of these debts. Usually if prices fall, firms will cut wages. Therefore you have less money, but you still have to pay the same level of debt back. With deflation, people have to spend a higher % of their disposable income on debt repayments. Therefore deflation can increase the number of bankruptcies and reduce spending, especially amongst people with high levels of debt.
3. Real Wages too high. Workers resist nominal wage cuts, so firms cannot afford to pay workers leading to higher unemployment.
4. Real Interest rates too high. Nominal interest rates can’t fall below zero. Therefore, with deflation, real interest rates become high and it becomes more attractive to save, causing a fall in spending.
5. More difficult for prices to adjust. With a moderate inflation rate, it is easier for relative prices to adjust, but with deflation this is more difficult.
Question: But, isn’t it good that new technology has reduced the price of computers?
Yes, if prices fall due to greater productivity and technical innovation then this is beneficial as we get lower prices but also greater output. Deflation is not necessarily a bad thing. If deflation is caused by technological innovation and increased productivity, it could be beneficial.
However, usually deflation is caused by a fall in aggregate demand and low growth. Deflation then reduces economic growth further.
5. Government Spending and Tax
What does the government spend money on?
In 2010/11, the UK government spent just under £700bn.
The main areas of government spending are:
• Social security £194bn – (pensions, unemployment benefit, sickness benefit, housing benefit)
• Health £122bn • Education £89bn • Defence £40bn • Debt Interest £44bn (interest payments on UK government debt) • Public order and safety £35bn • Transport £22bn • EU Membership £6.4bn
Spending in £ billions
Out of interest:
• Cost of Royalty (Head of state) £38.2 million in 2010
How much tax does the Government Get?
In 2010-‐11
• National insurance £96bn (a type of income tax on employers and employees)
• Income Tax -‐ £151bn • VAT -‐£86bn (20% on many goods) • Corporation Tax -‐ £42bn (tax on firms’ profit) • Fuel Duty -‐ £27bn – (petrol tax) • Business rates-‐ £23.8bn (local business rates) • Council tax -‐ £25.7bn • Capital gains tax -‐ £3.2bn (profit on investment) • Inheritance tax -‐ £2.7bn • Stamp duty land tax -‐ £6.0bn • Stamp taxes on shares -‐ £3.0bn • Alcohol -‐ £9.5bn • Air passenger duty -‐ £2.2bn • Insurance premium tax -‐ £2.5bn • Climate Change Levy -‐ £0.7bn • Vehicle excise duties -‐ £5.6bn
Total Tax £550bn
6. Government Borrowing
Governments are very good at spending more money than they receive in tax. If they spend more than tax revenues, they have to borrow to make up the shortfall.
Annual Budget Deficit
In a particular year, the government may have to borrow a certain amount. E.g. 2010-‐11, the UK public sector borrowing was approx. £149bn or 11% of GDP.
This deficit is because the government spending of £700bn is greater than the governments tax revenue of around £550bn.
This means the government borrowed approximately £2,400 per person in the country.
National Debt
This is the total amount the government owes. For more than 300 years (1693 to be precise), the UK government has been accumulating debt. In 2012, the government’s total debt (called public sector net debt) was approximately £1,000bn or 64% of GDP – or an average of £10,000 per person in the economy.
Question: How does the government borrow?
The government sells bonds to the private sector. (Also called gilts, government securities, and in the US, Treasury bills). This is basically an “I Owe You”. People purchase a government bond for say £1,000. In return the government pay a rate of interest (say 5%) until the end of the loan period where the government will repay the full £1,000.
The loan may last for 3 months to 30 years. In the UK, government bond sales are managed by the Debt Management Office
Q. Who Does the Government Borrow from?
Essentially it is the private sector that lends money to the government by buying bonds. For example, banks, investment trusts and pensions will buy government bonds. If you have a private pension, indirectly you are probably lending money to the government because your pension fund probably holds some government bonds. Individuals can also buy government bonds.
Note: In some circumstances, a Central Bank (e.g. Bank of England) can purchase government bonds. During 2009-‐11, the Bank of England pursued a policy of quantitative easing. This involved creating money electronically and buying assets such as government bonds. Therefore, in 2012, a proportion of UK government debt was held, not by the private sector, but the Central Bank.
Does the Government Borrow from abroad?
Usually governments don’t borrow directly from abroad. However, foreign investment trusts and individuals can buy UK bonds. Roughly 20-‐30% of UK government debt is held by foreign companies and individuals. In Japan, most Japanese government debt is held domestically. The US also has about 25% of its public sector debt owned by foreign companies.
Therefore, when we talk about UK public sector debt, in a way, we are borrowing from ourselves. The UK government borrows from the UK private sector.
Government Bailouts
Sometimes a government may have to borrow from abroad when they face a crisis. For example, in the 1970s, the UK government had to borrow from the IMF to meet a shortfall in the budget. In 2011, the European debt crisis did force some governments to borrow from abroad. Countries like Ireland and Greece were forced to borrow directly from financial institutions and countries abroad.
Governments will obviously try to avoid needing a bailout. It is embarrassing to have to ask other countries to bail them out. Also, if the IMF lends you money they will usually require certain conditions (like increasing tax and reforms to the economy which may be politically unpopular.)
Difference between Trade Deficit and Budget Deficit
It is important to remember government borrowing is completely separate from the trade deficit and the current account deficit (The trade deficit deals with imports and exports). The budget deficit deals with government spending and tax revenues.
Central Banks and Government debt.
Usually the government borrow from the private sector. But, in some circumstances, the governments’ shortfall can be met in a different way.
The Central Bank e.g. the Bank of England can create money to buy government bonds. This is a rather nifty way of temporarily dealing with your debt because the Central Bank literally creates money out of thin air and buys government bonds. Thus government debt is being financed by their own central bank.
This occurred during the process of quantitative easing. Central Banks in US and UK created money and used this ‘created money’ to buy Government bonds.
Note, the purpose of quantitative easing is not supposed to be to finance the deficit. The aim is to increase the money supply to boost growth and reduce interest rates to improve lending and investment levels.
But, as a side effect of quantitative easing, in the short term, the government doesn’t have to borrow so much from the private sector.
Also, if quantitative easing is successful and increases the rate of economic growth, this will help to boost tax revenues, which will help to reduce government borrowing.
There is an old saying money doesn’t grow on trees, but actually Central Banks can create as much money as they want. For them money can be created out of thin air.
Question: Why doesn’t the government print money to pay off its debt?
This is the great temptation. A government / Central Bank with own currency can in theory print money and pay off its debt. Yet, this has the potential to be a real disaster. (This is what Weimar Germany did in the 1920s leading to the famous case of hyperinflation.)
Firstly, printing money doesn’t create any output. We have the same number of goods and services. If you double the amount of money in the economy, the actual output will stay the same.
But, if you double the money supply, people have more cash and are willing to pay more for the same number of goods. Therefore, firms will put up prices, and we will just see a rise in inflation. In a very simple model, doubling the money supply (amount of money) will double prices. Inflation will be 100% but output will be exactly the same.
Therefore all that happens is that things are more expensive and the high inflation creates uncertainty.
But, there are other problems to printing money.
• People who bought government bonds, see their value halve. The government is due to pay them £1,000, but inflation has reduced its value so it is really only now worth £500.
• Increasing the money supply will reduce the value of Sterling. Foreigners won’t want to hold UK government debt because the value of sterling is falling and the value of UK bonds decreases.
• The result is that people will be more reluctant to hold UK government debt in the future because people who bought bonds have become worse off.
E.g. who would want to buy government bonds in Zimbabwe after the period of hyperinflation and fall in Zimbabwean dollar?
Therefore printing money creates inflation and reduces the value of bonds and savings. This makes it very difficult for government to borrow in the future, because investors won’t trust governments who print money and reduce the value of money.
Question: So, if printing money creates inflation why has the UK and US done exactly that? Are we not going to end up like Weimar Germany?
In 2009-‐11, the UK and US pursued quantitative easing -‐ which involved increasing the supply of money (in particular it was narrow money – the Monetary Base which increased)
(Technically it is not printing money but the overall effect is pretty much the same.) Yet, core inflation remained very low.
Question: How Can you Print Money Without Causing Inflation?
At the risk of over-‐simplifying, in a deep recession (liquidity trap) it is possible to increase the amount of money in the economy without creating inflation.
The money supply does not just depend on the amount of cash, but also how frequently it changes hands. In a recession, money will not be spent as frequently, and banks will be reluctant to lend.
Therefore, even if banks see an increase in their bank balances they may not lend it to consumers. Also consumers will be saving more and spending less. (People are metaphorically keeping more under their mattresses.)
Therefore, the Central Bank may have increased the amount of money in circulation, but it is being stored and not used.
• In a period of economic growth, cash is frequently being used and changing hands frequently.
• In a recession, even if you create money it may just be saved.
If you print money during a period of normal economic growth, it is almost certainly going to cause inflation. This is because banks will lend the extra money and people will spend it.
But, in a recession, in a time when people hoard money and it is not being spent, it is very unlikely to occur. In fact the Central Bank may increase the money supply to try and avoid deflation.
Some argue that in a liquidity trap, with a falling velocity of circulation, a Central Bank can actually create money and pay off government debt permanently, without causing inflation.
This graph shows that during the period of quantitative easing 2009-‐2011, M4 lending to private sectors was often negative, much lower than trend. This shows that quantitative easing failed to cause a boom in M4 money supply growth as some economic theory would predict.
Note: M4 is called ‘broad money’. It includes: notes and coins plus bank and building society deposits.
Narrow Money Supply
Notes and Coins is a narrow definition of money – as it suggests it is the amount of notes and coins and is similar to an old definition of money supply called MO.
Controversy
Of course, there is a potential problem that when the economy recovers and banks start lending, it may be difficult to withdraw all the extra money in circulation and we get delayed inflation. But, under certain circumstances, Central Banks have increased the money supply without causing any inflation.
In the UK, quantitative easing didn’t cause underlying core inflation to increase. However, to complicate things there was a degree of cost push inflation in 2011 (due to rising petrol prices and higher taxes)
Is Government Borrowing Good or Bad?
Annual income twenty pounds, annual expenditure nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pound ought and six, result misery.
Charles Dickens, David Copperfield, 1849
This nugget of wisdom may apply to people in Dickensian novels, but when it comes to borrowing, governments are frequently prolific beyond our imagination.
The US public sector debt recently passed over $15 trillion. Many would have difficult comprehending how much $15 trillion actually is.
• Million = $1,000,000 • Billion = $1,000,000,000 • Trillion = $1,000,000,000,000 • 15 trillion = $15,000,000,000,000
A second may not seem a long time, but a trillion seconds is 31,688 years ago. A trillion seconds human civilisation had not begun. A billion seconds is just a blink of the eye in comparison (31 years ago)
Anyway, that is just a slight diversion to give an indication of the scale of the government borrowing.
Problems of Government borrowing
Economist suggest government borrowing can be damaging for the following reasons:
1. We have to pay interest on the borrowing. For example, the UK in 2011/12, paid roughly £47bn in interest to bond holders.
2. It can be a burden on future generations, as they have to pay interest on our debt.
If borrowing increases too much (i.e. an unsustainable amount of debt to GDP):
1. Investors may be less willing to buy government bonds. If markets think that the Greek government may default (not able to pay back bond holders) then the Greek government won’t be able to sell bonds to finance its debt. This leads to a fiscal crisis.
2. Higher interest rates. If people fear a government may default, their debt is seen as more risky. To compensate for the risk, interest rates on bonds will have to increase. If people trust a government to definitely repay, they may accept a low interest rate. But, if people worry they could lose money, they will only buy if interest rates are higher.
3. However, higher interest rates can lead to lower growth and more unemployment. Higher interest rates also increase the cost of borrowing for the government.
4. Inflation. It is possible that if government borrowing increases too much they may be tempted to increase the money supply to finance the deficit, which causes inflation. This will also weaken the value of the exchange rate.
5. Crowding out of private sector. If the government borrow from the private sector, there will be fewer funds for private sector investment. Also, if borrowing pushes up interest rates, higher interest rates also crowd out private sector investment.
Question: Is Britain Bankrupt?
In 2007, UK public sector debt was £500bn. In 2012, this had increased to over £1,000bn. If you include financial sector intervention, debt is closer to £2,300bn
If you include future pension commitments (ageing population and governments commitment to pay pension), the fiscal state is even worse.
However, even with this scale of debt, Britain is not bankrupt.
Firstly, this level of debt is not a new thing. The UK has been through higher levels of public sector debt in the past.
This graph shows that after the two world wars, the UK had a dramatic rise in government borrowing, reaching a peak of 240% of GDP in the 1950s.
One way of thinking about debt is how much do you have to spend on the interest payments to finance the debt. In the UK’s case, debt interest payments of £45bn a year sound a lot, but it is only equal to about 3% of GDP. Therefore it is manageable.
If you take out a mortgage, you may spend 30% of your disposable income on mortgage payments, but you don’t consider yourself bankrupt. It is a manageable amount.
At the present time Britain is not bankrupt and has been through worse in the past. However, just because the UK isn’t bankrupt doesn’t mean we don’t have a serious level of government borrowing -‐ a level that is unsustainable in the long term.
What does Debt as a % of GDP mean?
• If you have an income of £10,000 and debts of £10,000. Your debt is 100% of your income.
• If your income doubles to £20,000 and your debt increases to £12,000. Your debt as a % of your income falls to 60% of your income.
• Therefore, an increase in debt is not so bad, if your income increases at a faster rate.
It is the same principle with government debt as a % of GDP.
• GDP is national income (the total of everyone’s income in the country)
• Therefore, if GDP rises faster than debt, the debt to GDP ratio will fall. • Usually Real GDP may increase by about 2.5% a year. Therefore if debt
rises by 2.5% a year than debt as a % of GDP stays the same. • This means economic growth is very important for making debt more
manageable.
Rising Debt to GDP Ratios
• After the recession of 2008, UK debt rose at a very fast rate. But, GDP fell. Therefore, we saw a sharp rise in the ratio of debt to GDP.
• The worst combination is rising debt and falling GDP. This occurred for many European countries in 2008-‐12
Why is Debt as a % of GDP important?
If debt to GDP stays the same, we will typically spend the same % of tax revenue on debt interest. Therefore, we don’t need to increase tax rates.
If the debt to GDP ratio increases, we may have to increase tax rates to pay the higher rate of debt interest.
Also, if debt to GDP ratio rises, markets may worry about the affordability of debt. Therefore, this tends to push up interest rates making it more expensive for the government to borrow.
Reducing Debt to GDP Ratios
To reduce debt, may require spending cuts and higher taxes. However, higher taxes could cause lower economic growth. Therefore, although we reduce debt, if GDP falls, we may not improve debt to GDP ratios. It can become a vicious cycle.
Some economists argue policies of fiscal austerity (spending cuts) can become self-‐defeating if there is nothing else (e.g. loose monetary policy, devaluation) to boost economic growth.
Bond Yields
“I used to think that, if there was such a thing as reincarnation, I wanted to come back as the president, or the pope, or a .400 baseball hitter. But now I want to come back as the bond market. You intimidate everybody.”
-‐ James Carville, campaign manager for US President Bill Clinton.
Bond yields are frequently mentioned in the financial news, yet it is a topic people are likely to have only a vague understanding about.
Bond markets can send governments into panic and create devastation in an economy, but why are they so important? Is it good or bad if bond yields increase? Why do bond yields rise when the price of bonds falls?
Bond Yields and Price of Bonds
• Let us suppose a government sells a 30-‐year bond worth £1000. • On this bond the interest rate could be set at 5% = £50 per year. • You could buy the bond and hold onto it for 30 years. In this case, you will
get paid £50 every year and at the end of 30 years, the government will pay back the original £1,000.
However, you can also buy and sell this bond on the bond market, e.g. after five years you may want to spend the money so you can sell your government bond to someone else. They will then own it and receive the interest payments until the end of the period.
• If more people want to buy bonds, the market price will increase. For example, the bond may increase in value to £1,500.
• But, the government will still only pay £50 a month interest. Therefore the effective bond yield is 50/1500 = 3.33%.
• Therefore, as the price of bond rises, the effective yield falls.
• However, if people were nervous about holding government bonds, they would sell bonds. This would mean the price would fall.
• The government bond could fall in price to £600. However, this bond still pays £50 a year. Therefore, the effective interest rate is 50/600 = 8.3%
• Therefore as bond prices fall the effective yield will increase.
What Does This Mean?
For example, if investors are nervous about Greek debt, they don’t want to hold Greek bonds unless there is a high interest rate to compensate for the risk. Therefore, people sell Greek bonds, and this causes interest rates to rise in compensation.
Higher bond yields may indicate investors fear a default in that country.
Are Rising Bond Yields Always Bad?
Rising bond yields may indicate people are worried about a countries ability to repay and so are selling bonds and demanding higher interest rates. Therefore rising bond yields can indicate government debt is too high (e.g. case of Ireland and Greece in 2010)
However, there is another reason why bond yields may increase.
• If people expect higher economic growth, they will also expect interest rates to start rising.
• Therefore government bonds may be sold, as people want to buy more profitable assets (such as shares) with a higher yield.
• Therefore rising bond yields may occur because people are optimistic about the future and are expecting an upturn in the economic cycle.
In a recession, government borrowing increases. You might expect this to cause higher bond yields (people worry the government is borrowing too much). However, often this doesn’t occur. In a recession, investors often want to buy government bonds, which are seen as safe, rather than risky private sector investment. Therefore in a recession, we often see bond yields fall, until the economy starts to recover.
But, if governments borrow too much (like Greece), then yields will rise because investors fear a default.
To some extent it depends – do you trust the government to repay? Japan has borrowed 225% of GDP, but people still trust the Japanese government to honour debt without creating inflation, therefore the Japanese keep buying Japanese bonds. (Japan is also helped by high levels of domestic saving)
EU Debt Crisis
Question: Why did bond yields on UK debt fall, whilst bond yields on other countries such as Spain, Italy and Ireland rose rapidly?
Firstly in 2011, the UK had a bigger budget deficit than all these countries. Bond Yields in the Eurozone rose rapidly because:
• Markets were pessimistic about the overall prospects for Eurozone debt. Problems in Greece showed markets that being in the Euro was no guarantee. Greece partially defaulted on its debt, a rare occurrence for a sovereign nation.
• No Lender of last resort in the Euro. One important difference between the UK / US and the Eurozone is that the UK and US have a Central Bank willing to act as lender of last resort. This means if there is a shortage of people buying bonds, the Central Bank is willing to create money and buy bonds. Therefore, investors don’t fear a liquidity shortage in the UK. But, they do fear this in the Eurozone; therefore they are less willing to buy Eurozone bonds, pushing up interest rates.
To Summarise
1. If investors think a government may default, this will reduce demand for bonds and push up yields (interest rate)
2. Bond yields also change depending on prospects for growth. Higher growth tends to push up bond yields as investors sell bonds for more profitable assets.
How Much Debt Can a Government Borrow?
There is no simple answer to how much a government can borrow.
• In the 1950s, the UK borrowed over 200% of GDP (helped by loan from US) In 2012, we are only borrowing 64% of GDP, but it is a different situation.
• Japan’s national debt is over 225%, but markets don't seem worried because at the moment, Japanese savers are willing to buy Japanese governments bonds.
• In Ireland, markets become worried when debt as a % of GDP rose to over 100% of GDP.
In short there is no easy answer to how much a government can borrow.
It depends on:
• Do people want to lend the government money? (do people want to buy bonds?) E.g. in Japan the private sector has a large appetite for buying government bonds.
• Prospects for growth. If an economy is forecast to grow, it makes it easier to pay off debt and reduce the debt to GDP ratio. If an economy is forecast to go into recession (lower output) then they are likely to get lower tax revenues and it becomes harder to pay off debt.
• Reputation of the country. If a country has never defaulted, investors are more likely to trust the fact that the bond is safe. But, if you get a reputation for defaulting it can be harder to attract investors.
• Does the government have a credible plan to reduce the budget deficit? If a country is paralysed by political weakness it can be difficult to agree on politically unpopular tax rises and spending cuts.
• Being in the Euro and single currency seems to make it more difficult to borrow. Countries in the Euro have less room for manoeuvre; they can’t ask their Central Bank to buy government debt. Also they can’t devalue the currency to promote greater competitiveness.
Q: Why Do Economists Suggest Government Borrowing to deal with the problem of Debt?
The credit crunch was caused by excess borrowing and bad loans, therefore why does the government start borrowing more? Surely they should be doing the opposite?
The problem with the credit crunch was that the private banking sector lost money. This caused a fall in aggregate demand and a fall in GDP (output).
In a recession, people become nervous about spending; they start saving more. (E.g. in the UK, the saving ratio rapidly rose from 1% to 5% at the start of the recession.)
For an individual it makes sense to save more and spend less when you could be made unemployed.
However, if everyone in an economy starts saving and spending less it causes a large fall in economic output, higher unemployment and a deep recession.
The economist John M Keynes argued that in a recession, the fall in private sector spending needs to be offset by a rise in government spending.
If the government do nothing, there is a sharp fall in spending and output declines. However, by borrowing the government can inject money into the economy and help the economy recover. When the economy recovers the government will receive higher tax revenues and can spend less on unemployment benefits.
Overall borrowing in the economy is not increasing. The government borrow more, but they are compensating for the rise in private sector saving.
All economists do not accept this theory of Keynesian economics. However, the essential argument is that in a recession with mass unemployment, the government should borrow to create demand that is not there.
In times of growth, the government should reduce its borrowing.
Q: But, doesn’t Government borrowing reduce the size of the private sector?
If the economy is growing and the government increase spending by borrowing from the private sector, it will mean the private sector have less funds for investment. In other words, the government increase spending but we get a corresponding fall in private sector spending. (This is known as crowding out)
However, in a recession it is different, the private sector want to save. There is high demand for government bonds because these are seen as a good way to save money. Therefore, in a recession, the government is just trying to use resources, which are currently idle. The government is not crowding out the private sector because they private sector are not investing.
Question: Does Government Borrowing Increase Interest Rates?
If government borrowing increases it requires more people buy bonds. If the economy is doing well, investors may not want to buy government bonds unless interest rates on bonds increase. Therefore to attract people to buy bonds, interest rates need to rise
However, in a recession, interest rates may not increase because there is a high demand for buying government bonds, even at low interest rates. (In a recession, there are fewer alternatives for investing in secure trusts)
In the above diagram, interest rates on 10-‐year bonds increased in Ireland and Spain because markets were worried about the government’s ability to repay.
In the UK, interest rates actually fell from Nov 07 to Feb 2011 because there was strong demand for UK bonds.
Question: What is the Best Way to Reduce Government Debt?
The problem with reducing government debt is that it can cause other problems. Suppose a government decided to immediately tackle its budget deficit. It could increase tax rates and cut government spending. However, the effect of this would be to reduce consumer spending and overall aggregate demand. Spending cuts would lead to unemployment and higher taxes would lead to lower consumer spending. The combined effect of this would be to cause lower economic growth.
If these austerity measures did cause a fall in economic growth, then the government would receive lower income tax and have to spend more on
unemployment benefits. Also, lower GDP would have the effect of increasing debt to GDP ratios.
Credit rating agencies often downgrade government debt on forecasts of lower economic growth.
When economic growth is very strong, then it is much easier to cut government spending without halting an economic recovery.
It also depends on what the government cut spending. If the government make public sector workers redundant there will be a big fall in spending and consumer confidence. However, if the government increased the retirement age, they could reduce their long term spending commitments on pensions without adversely affecting economic growth. In fact, making people work for longer may actually increase productivity.
It may be very unpopular to raise the retirement age. People who expected to retire at 65 may feel it is unfair to suddenly have to work an extra 5 years. However, from one economic perspective, it would be a way to reduce government borrowing without causing a fall in economic growth.
Why Do Attempts to Reduce Debt Cause Rising Bond Yields?
Several European countries that embarked on severe austerity programs often failed to reassure markets about the state of their finances. For example, spending cuts by Greece and Ireland, led to lower economic growth. This fall in tax revenues meant markets were nervous about their prospects to reduce debt to GDP.
It is an irony, markets can demand austerity measures because of rising government debt, but then markets punish countries who enter into recession as a result of their own attempts to reduce debt levels.
However, it is possible to reduce spending without causing a recession. For example, Canada in the 1990s had a large budget deficit. Canada cut government spending ruthlessly. However, this didn’t cause a recession because:
• The Canadian currency devalued making Canadian exports increase. • Canada benefitted from a boom in the US economy. • Monetary policy was relaxed (lower interest rates)
This shows austerity measures can work. But, it helps if you can boost demand by increasing exports or loosening monetary policy. Countries in the Eurozone don’t have this option because:
• They can’t devalue • They can’t pursue an independent monetary policy • Other European countries are also facing low growth.
Example: How did the UK Government Respond to the Great Depression in the 1930s?
The stock market crash of 1929 precipitated a dramatic fall in output around the world. It led to a fall in output, higher unemployment and a decline in trade. As a result government borrowing increased, (income tax revenue fell, and the government had to spend more on unemployment benefits)
However, at the time, the Treasury economists advised the government they needed to tackle the problem by reducing government borrowing. At the time, economic orthodoxy said it was important for governments to run balanced budgets and not borrow.
Therefore, in 1931 the Ramsay MacDonald National Government cut unemployment benefits and increased taxes. (The first Labour minority government got elected in 1929, but many Labour MPS resigned from government in 1931 over cutting unemployment benefits. The new coalition government was mainly Conservative MPs headed by Labour MP Ramsay McDonald.)
By increasing taxes and cutting benefits, it led to a further fall in consumer spending and lower growth. It made the recession deeper. In the UK, high unemployment persisted until the start of the Second World War.
It was against the backdrop of the Great Depression that John M. Keynes wrote his General Theory of Employment. It is quite a dense work and definitely not light reading. But, one essential idea was the notion that in recessions, governments needed to intervene to prevent persistently high unemployment.
The irony of the period is that two countries did pursue a dramatic increase in government spending – Germany and Japan. In these countries, unemployment fell as government spending on military and infrastructure increased. However, it is important to note, the effect on unemployment could have been the same if the government spending had been on education, health care and transport.
7. Balance of Payments
The balance of payments is concerned with the flow of transactions between one country and the rest of the world. It measures the level of imports and exports.
There are two main components of the Balance of Payments
1. The Current account – This measures trade in goods and services. 2. Financial / Capital account. Flows of capital (e.g. money deposits in
banks) and long-‐term investment.
The UK has a current account deficit. We import more goods from China than we export. E.g. if you look at many electronic goods / clothes it will say ‘Made in China’
On the other hand, China has a current account surplus with the UK. They export goods to us.
Q. What Happens when there is a current account deficit?
It means we are buying more imports of goods, therefore foreign currency is flowing to China. However, if we have a deficit on the current account, this needs to be financed by a surplus on the financial account. This could involve a flow of currency to buy financial assets or long-‐term investment
E.g. China may buy UK assets or UK government bonds. This means foreign currency comes from China, which enables us to import Chinese goods.
E.g. The US has a substantial current account deficit with China. The US buys cheap manufactured goods from China. China uses this accumulation of foreign currency to buy US government bonds and other US assets.
Therefore if you run a trade deficit (import more goods than export) then you need to have a surplus on the financial account.
Note: a current account deficit is completely separate to government debt.
Q. But, what happens if there isn’t a financial flow from China to UK. What would happen if China didn’t want to buy UK assets to finance the trade deficit?
If there were a current account deficit, but no flows to finance it, there would be a fall in the exchange rate. The demand for Chinese currency would be greater than Pound Sterling. Sterling would fall in value making UK exports cheaper. If exports were cheaper, this would increase demand and reduce the current account deficit.
Therefore, there is a mechanism to ensure the balance of payments balances. E.g. a deficit on current account must be matched by a surplus on the financial / capital account.
Trade Deficit
When talking about the balance of payments, people often refer to the trade deficit. A trade deficit implies we import more goods than we export. However, the trade deficit only comprises part of the current account. We need to also consider trade in services (e.g. insurance, banking) and investment incomes.
Question: Is it Harmful to have a current account deficit? (Trade deficit)
Back in the 1960s, there was a popular campaign to ‘Buy British’. Politicians were worried about the UK trade deficit, and there was an attempt to appeal to our patriotic sense of duty and buy British goods rather than import them from Japan. The problem is that patriotic duty is all very well, but when your British Leyland car breaks down for the third time in a week, German and Japanese efficiency looks much more appealing than the patriotism of buying an Austen Minor.
The UK has had a current account deficit pretty much ever since the early 1980s.
• You could argue a current account deficit is the sign of an unbalanced economy; a trade deficit is a sign our exports are uncompetitive.
• A current account deficit means foreigners are owning more of UK assets, e.g. China buying UK bonds and other assets. Russians buying UK property.
• The deficit may be unsustainable if we can’t attract enough financial flows to pay for our imports.
However, although a current account deficit is considered problematic it is much less important than in the 1960s.
• Globalisation has arguably made it easier to attract capital flows to finance the deficit. (Though the credit crunch showed the potential limitations of this argument.)
• A current account deficit means you can have a higher standard of living as you consume more imported goods and services (at least temporarily).
Sometimes countries with a large current account surplus have their own problems. For example, Japan has a persistent current account surplus. This is partly because of the competitiveness of their exports, but also because the Japanese consumer is reluctant to spend and buy imports. In Japan a large surplus is an indication of slow growth.
It is not as simple as saying current account deficit bad -‐ current account surplus good.
Current Account Balance as % of GDP
However, if you have a large current account deficit it is generally seen as worrying sign.
Example of Large Current Account Deficit
In 2011, Portugal and Greece both have a very large current account deficit (close to 10% of GDP)
This is because:
• Their exports have become uncompetitive • In the Euro, they can’t devalue their exchange rate to improve their
competitiveness.
8. Interest Rates
Interest rates are the cost of borrowing money. If you get a loan from a bank they may charge an interest rate of 8% a year. By charging interest, the bank is able to make profit.
If you save money in a bank you may get an interest rate of 1-‐4%. This is your reward for saving money.
In a very simple model of the banking system, banks attract savings by paying interest to savers and then lend the money at a higher rate to people who want to borrow.
The difference between the saving and lending rates is effectively their profit margin.
Different Types of Interest Rates
There are many different types of interest rates in the economy. Some of the most common include:
• Interest rate on your current account (0-‐1%) – you get instant access to money, but the bank pays little interest on your savings.
• Saving accounts (4%) – In a saving account you get a higher rate of interest rate, but you might have restrictions on when you withdraw money (e.g. 7 day notice). This makes it easier for banks to plan and lend your savings out to other people.
• Mortgage Loans (5%) – A mortgage is a special type of loan. The loan is secured against the value of your house and the repayment is spread over a long period of time. A secured loan means that if you can’t pay, the bank can claim your house as compensation. This makes a mortgage loan less risky for a bank because they always can sell your house so they don’t lose everything.
• Unsecured personal loan (8%). An unsecured loan is not guaranteed by any asset. It is more risky for the bank. Therefore, they charge a higher interest rate to compensate for the risk.
• Credit Card Loan (18%). Borrowing on a credit card can be very expensive. If you only pay the minimum each month you can find the amount you owe continues to increase.
• Pay Day Loans / Loan Sharks (100%) Many people in the UK don’t have a bank account. This makes it difficult for them to borrow money. Therefore they may turn to pay day loans or unofficial borrowing channels. These lend money for a short time period – several days, at effectively very high interest rates. Loan sharks refer to unregulated lenders who can charge very high interest rates to people without access to ordinary credit.
• Interest rates on government bonds. This is the current interest rate that you can get if you buy government bonds. They are often known as bond yields, because it is the amount of income you get from holding a bond. The bond yield on a 10-‐year government bond is 4.11% in 2011.
Interest Rates and the Bank of England
The Bank of England is an independent body responsible for looking after aspects of the economy (monetary policy and inflation).
The Bank of England can control the base interest rate. By changing the base interest rate they can affect all the different interest rates in the economy.
• It is a little complicated, but the Bank of England acts as banker to the commercial banks. (E.g. If Lloyds TSB is short of money they can borrow from the Bank of England) The rate Lloyds TSB borrows from the Bank of England is known as the base rate.
• If the Bank of England increases the base interest rate, it makes it more expensive for Lloyds to borrow money. Therefore, Lloyds TSB are likely to increase their own interest rates for savers and borrowers.
• Therefore indirectly the Bank of England can influence all the main interest rates in an economy.
If that doesn’t make too much sense, it is fine to just know the Bank of England set the base rate and this influences all the other interest rates in the economy.
Q. Why Would the Bank of England Increase Interest Rates?
The Bank of England is supposed to keep inflation close to the inflation target of 2%. Therefore if they believe the economy is growing too quickly and inflation is increasing, they can increase interest rates.
This increase in interest rates leads to slower growth and helps reduce inflation.
This is known as tightening monetary policy. When economic growth is very high, it is like a tap turned to full. The water is coming out very fast, but because the water is coming too fast it may spill over the sink (inflation)
By increasing interest rates, the Bank is trying to turn down the tap (reduce the growth rate). They hope to keep the water flowing (positive economic growth) but avoid the water coming out to fast (inflation).
In theory the bank can change interest rates to influence the speed of economic growth and inflation. But, unfortunately it is not quite as simple as turning a tap on and off.
Impact of Increasing Interest rates
If the Bank thinks inflation is increasing, they may decide to increase interest rates to reduce growth and inflationary pressure.
If interest rates increase it affects many people in the economy.
• People with mortgage payments will face higher monthly mortgage payments. Therefore they will have less income to spend.
• It will be more expensive to borrow money (take a loan out). Therefore it will discourage firms and consumers from borrowing. Therefore this will lead to less spending and investment.
• Saving will give a higher rate of return. Therefore saving money may be more attractive than spending.
• Higher interest rates make it more attractive to save money in British banks. This increases demand for British currency and therefore the value of the pound increases. This makes exports more expensive and leads to lower demand for exports
The overall effect of higher interest rates is that it tends to reduce spending and demand in the economy. It leads to lower economic growth and can help reduce inflation. However, the lower growth can cause higher unemployment.
Impact of Cutting Interest Rates
If there is a fall in output and an increase in unemployment, the Bank will tend to cut interest rates to try and boost economic growth. This is known as a ‘loosening of monetary policy’. You could imagine the bank opening up the tap to encourage the flow of spending and economic growth.
Therefore, in theory, the Monetary Policy Committee (MPC) of the Bank of England has enormous influence over the economy. If they want to target higher growth they can cut interest rates, if they want to reduce inflation they can increase interest rates.
Interest rates used to be set by the government. But, governments had a habit of cutting interest rates just before an election. This caused higher growth, lower unemployment, cheaper mortgage payments and helped make them more electorally popular. However, it often caused inflation to occur. Therefore after the election the economy experienced high inflation and it was difficult to reduce it. This system often led to a boom and bust economic cycle (high growth and inflation followed by fall in output)
Therefore, the responsibility of setting interest rates was given to the Bank of England. It was hoped that an independent body would not be influenced by political consideration and avoid boom and bust cycles….
For several years, they were successful – during 1997-‐2007 there was a period of low inflation and positive economic growth.
However, the credit crunch and great recession (2008-‐11), showed the limitation of relying on the Bank of England to control the economy through just using interest rates.
With one policy tool (interest rates) it is not possible to simultaneously target, inflation, unemployment, house prices, banking lending e.t.c.
Problems of Monetary Policy
In theory, the bank can target economic growth and low inflation. In practise it is often much more difficult.
Q. Why might cutting interest rates fail to increase economic growth?
(Source of base rate, Bank of England series IUMAAMIH)
In the middle of the credit crunch in 2008, the bank cut interest rates from 5% to 0.5%. In theory, this cut in interest rates should increase consumer spending and investment and cause strong economic growth. However, the record low interest rates failed to return the economy to normal economic growth. This was because:
• The recession was very severe. People had no confidence to spend. If you think you might be made unemployed, you tend to increase your saving and not buy expensive items – even if interest rates are low.
• Banks had lost a lot of money in the credit crunch. The banks had lost vast quantities of money because they bought into US mortgage bundles that became worthless when there was a rise in US mortgage defaults. Therefore, the banks had no money to lend.
• Although base rates were very low, it was very difficult to get a loan. In other words, it might have been cheap to borrow, but it was hard to find a bank who would actually lend you anything.
• Falling House prices. In 2007, house prices were overvalued and after the credit crunch started to fall. When house prices fall, consumers lose wealth and therefore they have less confidence to spend. Falling house prices are also bad for banks that now lose more money on mortgage defaults. In theory, low interest rates should make it cheap to buy a house (low mortgage payments). But, low interest rates didn’t stop house prices falling because banks became very strict about mortgage lending.
• Time delays. If you cut interest rates not everyone benefits. People may have a two year fixed mortgage. This means the interest rate on their mortgage won’t change for two years when they remortgage.
• If you remember the analogy of the tap. The bank can turn up the flow of water. But, in practise it is like having a tap, where there is an 18-‐month time delay before it reacts to turning it on.
• Commercial banks may not pass on the base rate cut to consumers.
(Source: of base rate Bank of England series IUMAAMIH -‐ SVR BofE series, IUMTLMV)
This graph shows how during the credit crunch, commercial banks kept their Standard Variable Rates (SVR) higher than the Bank of England base rate. When the Bank of England cut base rates, commercial banks didn’t follow suit.
The commercial banks didn’t cut their SVR rates because they wanted to improve their liquidity and attract more deposits rather than lend money out.
The Problem of Rising Oil Prices
Q. How do rising oil prices affect the economy?
• A rapid rise in oil prices leads to an increase in costs for firms (e.g. transport costs). This increase in costs will be passed onto consumers. This leads to higher inflation
• However, it also leads to slower economic growth. Consumers face a higher cost of living and so have less disposable income to spend.
• Therefore, unfortunately, rising oil prices can lead to both inflation and lower growth at the same time.
• This combination of inflation and lower growth is sometimes referred to as stagflation. Stagflation occurred in the 1970s after the oil price shocks.
Question: How Should we Respond to Higher Oil Prices?
In the short term, it is difficult.
• The MPC could increase interest rates to reduce inflation, but growth is already falling. Higher interest rates would lead to even lower growth.
• The MPC could cut interest rates to boost growth, but this will cause inflation to be even worse.
Basically, rising oil prices makes everything more difficult. We have to accept higher inflation or lower growth or both. We have a worse trade-‐off.
Oil prices in 2008 caused a rise in inflation to 5%. But, at the same time GDP fell dramatically. We had similar stagflation in 2011, with rising inflation and falling economic growth.
However, it is worth remembering, oil prices are often volatile, so the inflation many be temporary, e.g. at the start of 2008, inflation was 5%. By the end of 2008, inflation had fallen to 0%.
Therefore Central Banks may not increase interest rates when inflation is caused by rising oil prices. But, it can be unpopular as people see falling living standards and higher prices.
In the long term, higher oil prices may encourage firms to develop alternative fuel sources. Consumers may be encouraged to find alternative means of transport. Therefore, in the long term it can have some benefits.
9. Banking System
Banks play an integral role in the modern economy.
• They allow you to deposit your savings in a safe place and earn you interest.
• Banks can lend money to firms and consumers. This enables them to buy expensive items and invest. Without being able to borrow from a bank, firms would find it very difficult to invest and grow.
• Economic growth would be very low if banks didn’t lend money for investment.
Q. How Do Banks Work?
• When you deposit £1,000 at a bank. It doesn’t keep all that in its vaults for when you want to withdraw it. This would not give the bank any profit.
• What the bank does is to lend most of this (say £900) to firms and consumers who want to borrow. The bank charges interest to firms and consumers and so makes profit on lending.
• The bank relies on the fact that its depositors won’t simultaneously ask for their deposits back.
• In fact, banks may keep less than 1% of their total deposits in cash. • A traditional building society encourages people to deposit in saving
accounts so it can lend mortgages to its customers.
Q. Why Did Banks Lose So Much in Credit Crunch?
Basically banks made loans to people who couldn’t pay them back. This occurred particularly in the US, where banks gave mortgages to people on low incomes who couldn’t really afford them. When people couldn’t repay their mortgage, the banks lost money. Also, house prices fell rapidly so the bank could only recoup part of the mortgage loan from selling the repossessed houses.
Banks also got involved in lending money to each other. Some European banks lost money because they had effectively lent money to US banks, who had made these bad loans.
Question: Why does the government bailout banks and allow manufacturing firms to go bankrupt? Surely good honest businesses deserve a bailout more than bankers who caused the credit crunch?
Most people would say your average businessman does deserve a bailout more than your average banker. However, in economics what people deserve is not always the best solution.
The government felt it was necessary to make sure banks didn’t go bankrupt because if even one bank went bankrupt, it would cause a severe loss of confidence and everyone would consider withdrawing money from their bank. A run on the banks (when everyone tries to withdraw their money) would cause a big fall in the money supply and a potentially deep recession.
The government didn’t want to bailout the banks, but, at the same time, they didn’t want to risk letting one go bankrupt and possibly causing a loss of confidence in the financial system. If there is a bank panic, it could have a devastating impact on the economy – affecting everyone. If a manufacturing firm goes bust, the impacts are largely confined to the workers and related firms.
Governments argue it is beyond their capacity to bailout out all private manufacturing firms. Also, it is difficult for the government to know which firms deserve bailing out. The fear is that if the government bailout an inefficient firm, and the firm will just remain inefficient.
However, there are times, when an industry is so large, the government may feel it is worth trying to keep it afloat. For example, the US government aid to General Motors in 2011.
Q. What would have happened if the government allowed Northern Rock to fail?
Northern rock lost money in the credit crunch. It was struggling to get enough funds to meet its commitments. If the bank had failed, depositors would have tried to withdraw their money (in fact there were long queues of people outside Northern Rock banks trying to do that before government announced the bailout).
The problem is that the bank couldn’t find the funds to pay all the depositors. The money was tied up in long-‐term mortgages and other loans.
• If the bank couldn’t pay depositors wanting their money back, this would cause a widespread lack of confidence in the banking system. Who would want to save their money in banks, when a bank can go bankrupt and you lose your money?
• It would encourage other savers to withdraw money from their banks and you would soon see long lines of people wanting to withdraw their money from their banks.
• Remember, banks don’t actually have enough money in their reserves to immediately pay all their depositors.
• Banks only keep a fraction of their deposits in cash. The rest is lent in long-‐term loans (e.g. mortgages) to earn the bank money. Banks know that in normal conditions people won’t ask for all the money back.
The banking system requires confidence. If people lose confidence then the banks face the prospect of their depositors wanting to withdraw all their money at the same time.
Bank Failures in the 1930s Great Depression
In the 1930s, the US did allow many banks to fail. There was no lender of last resort and many small regional banks went bust.
After people lost money on the stock market, people were queuing up all around America trying to get their money out of banks. But, banks couldn’t meet all the requests for money. The result was that 500 US banks failed in 1932 alone. This meant there was a rapid fall in bank lending and fall in the money supply. It also badly affected economic confidence.
This number of bank failures undoubtedly contributed to a catastrophic decline in money supply and output. The decline in spending led to a further rise in unemployment and a prolonged recession.
Question: Doesn’t that mean Banks can take risks -‐ knowing if they mess up the government will have to bail them out?
Yes, this is a real problem. If banks gamble and make high profits they can pay themselves large bonuses. But, if they lose money, the government effectively has to step in and bail them out. It is heads you win, tails the taxpayer loses.
Arguably the fact banks don’t have to be fully responsible for their actions encourages the risky behaviour we saw pre-‐2008.
Q. But, that seems wrong
It is. This is why there are calls to split banks into different sections -‐ retail and investment branches. In that case the government can guarantee retail savings, but not the riskier investment banks. If banks get involved in risky investment strategies, these parts of the bank can be allowed to fail.
The government can guarantee ordinary savings, but it doesn’t have to guarantee bankers speculating on credit default swaps. However, in practise, it may prove more difficult to split up banks. Even allowing ‘risky investment banks’ to fail could still cause a powerful loss of confidence in retail banks. E.g. Lehman Brothers failed in October 2008, causing a widespread collapse in financial confidence, but Lehman Brothers was mainly an investment bank not a retail bank.
Question: How Did the Credit Crunch Occur?
The simple answer: Banks lost money in bad investments. This was often money they didn’t have. In other words they borrowed money to lend to other people, but then people defaulted (couldn’t pay back) on these loans.
Credit Crunch Explained
1. US mortgage lenders sold mortgages to customers with low income
and poor credit (these are often referred to as sub-‐prime mortgages). There was an assumption US house prices would keep rising.
2. Often there were lax controls on the sale of mortgage products. Mortgage brokers got paid for selling a mortgage, so there was an incentive to sell mortgages even if they were too expensive and a high chance of default.
3. Mortgage companies also sold their own mortgage loans to other banks, e.g. British and European banks were buying these ‘mortgage bundles’ US mortgage companies were effectively borrowing money to be able to lend risky sub-‐prime mortgages.
4. Many banks were buying these risky sub-‐prime mortgage loans without fully realising how much risk they were exposing themselves to.
5. Many of these mortgages had an introductory period of 1-‐2 years of very low interest rates. At the end of this period, interest rates increased.
6. In 2006, after a period of very low interest rates, the US had to increase interest rates because of concerns over inflation. This made mortgage payments more expensive. Furthermore, many homeowners who had taken out mortgages 2 years earlier now faced ballooning mortgage payments as their introductory period ended.
7. Faced with rising living costs, many homeowners started to default on their mortgage – they couldn’t pay the expensive mortgage they took out.
8. As people couldn’t pay mortgages, people sold houses and demand for buying a house declined. This caused a fall in house prices, which many didn’t expect.
9. Banks lost money because people defaulted on their mortgage, but also house prices were falling rapidly. This meant they couldn’t recoup their losses by selling the homes they repossessed.
10. Because of the high number of mortgage defaults, US mortgage companies went bankrupt. But, also many banks around the world lost money because they had been lending money to these US mortgage companies.
11. Banks lost money, therefore to recoup their money they stopped lending to each other. It suddenly became very difficult to borrow money on short-‐term money markets.
12. Banks all faced greater liquidity problems. (Hard to get enough money)
13. This difficulty in borrowing affected confidence. It encouraged people to try and withdraw their savings making things even worse.
Question: Why British Banks Were Affected
If you remember the traditional model of a bank. -‐ The bank attracts deposits (savings). It can then use these deposits to lend to business and consumers.
• However, in the boom years many banks became greedy, they wanted to lend more mortgages than they had deposits.
• Therefore, banks started to borrow money at a low interest rates to lend at a higher interest to mortgage holders.
• This seemed a clever way of making money. New banks which used to be building societies (like Northern Rock, RBS and Bradford & Bingley) scorned the traditional model of banking (lend your own deposits). They wanted faster growth and more profit.
• It was fine to borrow money to lend when interest rates were low and credit freely available.
• However, the credit crunch meant that suddenly they could no longer borrow money at low interest rates. In fact they couldn’t borrow money at all.
• This is the problem Northern Rock had; it could no longer borrow money to finance its long term lending. It faced a shortage of liquidity because banks no longer wanted to lend to each other.
• Also, many commercial British banks had bought sub-‐prime mortgage bundles from US or had shares in other banks that had also been exposed to these ‘toxic debt’ bundles. This increased their losses.
Q. Why Did the Credit Crunch Cause the Recession?
• After the credit crunch, banks found themselves very short of cash (liquidity). Therefore, banks had to reduce lending to business and consumers. Therefore business investment fell and consumer spending fell.
• It became much more difficult to get a mortgage, therefore fewer people were buying houses. This caused house prices to fall leading to lower household-‐wealth and lower consumer spending; this caused a fall in real GDP.
• The frequent bad news (e.g. rumours of Northern Rock going bust) led to a collapse in confidence in the economy. People feared unemployment and so saved more, they tried to pay off debt and reduced their spending.
• The global nature of the crisis meant there was a fall in demand for UK exports because other countries were also experiencing lower demand.
10. Exchange Rates
Exchange rates reflect the value of a currency compared to others.
Depreciation / Devaluation
A depreciation (also referred to as devaluation in a fixed exchange rate) means a currency becomes weaker. For example, a depreciation in the pound means you will get fewer dollars for your money.
E.g. of depreciation in the Pound
• In 2007 £1 = $1.7 • In 2009 £1 = $1.5
A depreciation in the pound is bad news for UK tourists. It means visiting abroad will be more expensive. Imports will also be more expensive.
The good news is that a depreciation will make UK exports appear cheaper to foreigners. This will help increased demand for UK exports and boost manufacturing industry (which exports a high % of output).
Appreciation
An appreciation in the exchange rate means a currency becomes stronger. For example, it means one pound will give you more Euros for your money.
E.g. • In 2010 £1 = € 1.1 • In 2011 £1 = € 1.3
• An appreciation in the Pound Sterling is good for UK tourists. It means
when we travel abroad foreign goods appear cheaper. Imports will also be cheaper.
• An appreciation makes UK exports appear more expensive. Therefore there will be lower demand for UK exports.
Q. Why Does an Exchange Rate Increase in Value?
The value of the Pound will increase if there is more demand or lower supply of Pound Sterling on foreign exchange markets. Various factors can cause an appreciation in the exchange rate.
Short Term Factors
Higher UK interest rates. If UK interest rates increase relative to other countries, then saving money in a UK bank will give a relatively better return. If you have a large investment portfolio, you may want to move some money into British banks to take advantage of the higher interest rates. To save money in the UK requires an increase in demand for Sterling and this causes the exchange rate to rise. (This is known as hot money flows)
Increased Confidence. If investors become more optimistic about the UK economy – e.g. prospects for growth increase; this will tend to increase demand for sterling. Higher growth will lead to higher interest rates and investors will in the future move savings into the UK.
Speculation. Sometimes exchange rates can change for no apparent economic rationale. Investors may just become bullish (optimistic) about a currency, causing it to rise.
Safe Haven Satus. Related to speculation is the idea of a ‘safe haven currency’ For example, in the turmoil of the Euro crisis in 2008-‐11, the Swiss France became a very attractive option for currency traders. They felt Switzerland was immune to many of the problems in other European countries; this caused the Swiss Franc to appreciate rapidly. (In fact it appreciated so much, the Swiss Central Bank had to intervene to prevent it increasing any further.)
Therefore, sometimes, a currency rises because investors are nervous about all the other alternatives. In a global recession, some currencies will rise despite their economy being weak.
Long Term Factors
Lower Inflation. If the UK has relatively lower inflation than other countries, our exports will become relatively more competitive. This will lead to higher demand for UK exports and Pound Sterling.
Productivity Growth. If a country sees increased productivity and improved quality of its goods, their exports will be in higher demand. This will cause an appreciation in the exchange rate.
In the long term, relative inflation and competitiveness is the key factor in determining exchange rates. For example, in the post war period, the German D-‐Mark steadily appreciated against the Pound because the German economy was becoming relatively more efficient and competitive than the UK.
Q. Is it Good To have a Strong Exchange Rate?
A strong exchange rate is often seen as a sign of a strong economy. Therefore, politicians are often reluctant to see their currency fall in value. There are several advantages of having a ‘strong exchange rate’
• It is good if your exchange rate appreciates because your exports are becoming more competitive and you have an efficient economy. In this case the currency is strong because your underlying economy is strong and competitive. (E.g. Germany and Japan in post war period).
• The prolonged decline in Sterling, in the post-‐war period, was due to the fact we were becoming relatively uncompetitive.
• A strong exchange rate will increase living standards because imports are cheaper. This is important if countries import raw materials and food.
• A strong exchange rate will help keep inflation low.
However, sometimes, an economy needs a depreciation in the exchange rate. To maintain a strong exchange rate can be counter-‐productive.
If an economy has high unemployment, low growth, low inflation, uncompetitive exports and a current account deficit – this is an indication the currency is overvalued. In this case a depreciation can help increase demand for exports, boost economic growth and help reduce unemployment.
Example -‐ Greece in Euro
Since joining the Euro in 2000, Greek exports had become uncompetitive because of rising wages and inflation – relative to Germany and northern Europe. By 2010-‐11, Greece had a large current account deficit, low growth, and high unemployment. However, they couldn’t devalue the exchange rate to restore competitiveness. This led to persistently low growth, which aggravated their existing debt problem.
By contrast, the UK wasn’t in the Euro. In 2009, the Pound depreciated by 20% to restore lost competitiveness. This helped minimise the effect of the great recession on the UK economy.
Example – UK in ERM and Black Wednesday 1992
Whenever we have a bad day in the economy, we tend to refer to it as a ‘black day’.
We have:
• Black Monday • Black Tuesday • Black Thursday
It’s not very imaginative, a bit like calling every scandal ‘something gate’
Anyway, Black Thursday, is an interesting example of what can happen when a government tries to maintain a strong exchange rate.
• In 1992, the UK was in a deep recession. Output was falling and unemployment close to 3 million.
• The UK was also in the Exchange Rate Mechanism. This involved keeping the value of the currency at a fixed level. Roughly £1 = DM 3
In 1992, foreign currency traders thought that, because the economy was in recession, this value of Sterling was too high. Therefore private investors were selling pounds.
However, the government were committed to keep the Pound at a certain level. Therefore they had to intervene in the foreign exchange market. To prevent the value of the Pound falling, they did two things.
• They bought Pound Sterling, using its own foreign currency reserves. • They increased interest rates to make it more attractive to save money in
UK, and hopefully increase the value of Sterling.
However, there were three problems.
1. Interest rates were too high for the economy because the economy was in recession. The economy needed a cut in interest rates, but the government was doing the opposite to protect the value of the pound. This made the recession much deeper and more painful. In particular high interest rates made mortgage payments very expensive.
2. Markets didn’t believe the government could persist with high interest rates. They knew interest rates were far too high and was causing misery for homeowners.
3. Markets felt the Pound was overvalued and the government were fighting a lost cause only to try and save political face.
Investors like George Soros basically were betting the government would be forced to devalue. They were able to make billions of pounds profit by selling pounds and buying foreign currency from the British government.
• On one dramatic day, the pound was again falling below its fixed rate. • The government increased interest rates to 15%. A record for interest
rates; it was certainly completely unprecedented for the middle of a recession.
• By increasing interest rates to 15%, the government hoped to show that they would do everything in their power to maintain the UK in the Exchange Rate Mechanism.
• However, markets reacted in shock and disbelief. How could you have interest rates of 15% when the housing market was collapsing and the economy in recession?
• Rather than save money in British banks to take advantage of higher interest rates, investors continued to sell Pounds.
• A few hours later, the government realised its gamble had failed. There was nothing left they could do to maintain the value of the Pound. They
had run out of reserves and increasing interest rates had not worked. Therefore, the government announced that they would leave the ERM.
• Interest rates were cut, and the value of the Pound fell 20% on the foreign exchange market.
The government lost billions to investors like George Soros. But, the decision to give up a fixed exchange rate helped the economy to recover.
• After the devaluation, exports become more competitive and lower interest rates reduced the burden on mortgage holders. After cutting interest rates and devaluing the exchange rate, the economy recovered from the recession.
In this situation the economy needed a devaluation. Inflation was not a problem. The problem was low growth and high unemployment.
Since 1992, the UK government have not targeted the value of the exchange rate but allowed the currency to ‘float’ i.e. let it be set by market forces.
A strong exchange rate is good if it is caused by a competitive economy. But, to artificially keep the exchange rate above its market value, usually causes significant economic problems.
One benefit of this ERM crisis was that this experience of being stuck in a fixed exchange rate at the wrong level, was a factor in discouraging the UK from entering the Euro. At least, in the ERM, you can devalue. But, with a single currency, that is not possible.
11. The Euro
The Euro is a bold experiment to replace individual currencies with a single European currency – the Euro.
As well as a single currency, countries in the Eurozone have the same interest rate (monetary policy) set by the European Central Bank (ECB).
It means that if the UK joined the Euro, we would no longer set our own interest rate, but it would be set by the ECB.
Q. What are the Benefits of Joining the Euro?
• It makes it easier for business and consumers to travel around the Eurozone. You don’t lose money changing currency and trying to carry several currencies.
• It is easier to compare prices. With all goods priced in Euros it is easier to compare between different countries.
• It eliminates fluctuating exchange rates. 60% of our trade is with the EU. An appreciation in the Pound can make UK exports uncompetitive. However, in the Euro there would be no more fluctuations in the exchange rate with Euro members. Stable exchange rates would arguably encourage investment.
• Encourage harmonisation. The hope was that being a member of the single currency would encourage greater economic harmonisation. With a single currency there are supposed to be greater incentives to keep inflation low and government borrowing low.
Q. Why Has the UK not joined the Euro?
Even the most ardent Euro enthusiast would find it difficult to argue the UK would have been better off in the Euro. There are numerous difficulties of being in the Euro.
1. Interest Rates would have been wrong for the UK. In the Euro, interest rates are set for the whole Eurozone area. Therefore, if the UK experienced a deep recession, the ECB may not cut interest rates. Therefore we could have high interest rates when we need to boost economic growth.
2. No Independent Monetary Policy. After the Recession of 2008-‐09, the UK pursued quantitative easing. This involves increasing the money supply and buying government bonds. This helped to boost growth (or at least prevented a deeper recession). In the Euro, the Central Bank cannot do this so there is less flexibility. It would have been more difficult for the UK to respond to the great recession without having an independent monetary policy.
3. Lose ability to devalue currency. In the Euro you cannot devalue against other Euro members. Therefore, if your economy becomes
uncompetitive, the only solution may be a prolonged period of deflation and lower growth. After the credit crisis, the Pound Sterling depreciated 20% against the Euro. To some extent, this helped the UK economy recover. But, many other Euro economies suffered because their exports were overvalued and they couldn’t devalue.
4. Higher Bond Yields. If the UK was in the Euro, we would have had higher bond yields on government debt. This is because in the Euro, there is no lender of last resort (ECB are unwilling to buy bonds.) Therefore markets fear liquidity shortages in the Eurozone; this tends to push up interest rates.
5. The UK is more sensitive to interest rates. The UK has one of the highest rates of homeownership. Many in the UK have a large variable mortgage rate. This means when interest rates increase, it affects UK households significantly more than European countries where people are more likely to rent a house.
6. Deflationary Pressures. Countries in the Euro have needed to pursue fiscal austerity (spending cuts) because of rising bond yields. But, this causes lower growth, and there is no policy (e.g. devaluation) to help boost growth. Therefore, countries in the Euro have many factors contributing to low economic growth and deflationary pressures.
Q. What would make a single currency, such as the Euro, work?
1. Similar Inflation Rates. The biggest problem in the Eurozone is that some countries have had higher inflation (e.g. higher wage increases). This has made them uncompetitive, leading to lower exports and lower growth. But, they can’t devalue to restore competitiveness. Therefore, the Euro needs countries with similar inflation rates and a good deal of economic harmonisation.
2. Fiscal Union. True fiscal union would mean that countries shared a common Eurobond. There would be no Italian bonds or German bonds – just a Eurobond. This means the responsibility of debt would be shared.
3. Geographical Mobility. A single currency needs a great deal of geographical mobility. E.g. if unemployment is high in Alabama, it is relatively easy for a worker to move to another US state where there are more job vacancies. However, in the Euro, it is more difficult for a Spanish worker to move to Germany to get a job. (For example, language barriers, difficulty of moving.)
4. Fiscal Transfers. If some areas were lagging behind the rest of the Eurozone, they would need greater fiscal transfers to try and overcome geographical unemployment and harmonise economic growth between the different regions.
5. Limits on government borrowing. The debt levels of Greece were unsustainable, precipitating the Euro debt crisis. To be in the Euro, it will be necessary for governments to stick to certain budget levels. However, sticking to budget levels may constrain fiscal policy and cause lower economic growth in certain circumstances.
12. Globalisation
Globalisation refers to how different economies are becoming closer and more integrated. Features of globalisation include:
• Greater trade between different countries • Migration of labour between different countries, e.g. workers travelling
from Eastern Europe to work in UK. • Growth of global multinational companies who have a worldwide reach. • Growth in importance of organisations like the IMF and World Bank. • Economies more closely linked. A recession in one country tends to affect
all the others.
Globalisation is not a completely new phenomenon; when Marco Polo discovered an early trade route to China; he was an early pioneer of globalisation. You could say the whole of history is a gradual process of globalisation. The UK population is a potpourri of immigrants from Celts, to Vikings, Romans, Normans and later immigrants from old British Empire. It is just that in the last 50 years, certain factors have speeded up the process of globalisation, such as:
• Better communication. • Better transport making it easier to travel. • Improved technology, which has effectively reduced the distance between
people. • Growth of regional trading blocks (e.g. NAFTA, EU) • Importance of free trade to global economic growth.
Even in the nineteenth century, Japan pursued a policy of ‘self-‐sufficiency’ -‐ the idea that they would produce everything they needed and have no or little contact with foreigners. However, in their post war economy, Japan has become one of the world’s biggest exporters, despite having few natural resources. Their economy has become based on the features of globalisation.
Q. Is Globalisation beneficial or harmful?
Globalisation is quite a general concept and so evaluating its relative merits is difficult. Opponents of globalisation argue that:
• Growth of multinational companies reduces choice and makes it more difficult for small local businesses. Because of globalisation, there is a danger of cultural homogeneity.
• Globalisation has increased environmental degradation. The use of raw materials has led to a rapid decline in natural resources such as the destruction rain forests and bio diversity.
• The process of globalisation has exacerbated global inequality, with the poorest regions in sub-‐Saharan Africa not benefitting from the growth in living standards felt in the developed world.
• Globalisation has arguably enabled Multi-‐National Corporations to exploit low-‐paid workers in developing countries.
However, others defend the process of globalisation.
• Globalisation had helped increase efficiency of production leading to lower costs and prices.
• Greater specialisation enables economies of scale and lower costs. This leads to lower prices for consumers.
• Many poor countries have seen a growth in living standards due to the benefits of trade. For example, many South East Asian and Latin American economies have witnessed rapid growth in GDP and economic welfare in recent decades.
• There is no reason why the process of globalisation has to lead to environmental problems. The emphasis is for governments to promote growth and development whilst also protecting the environment.
• MNCs may seem to pay low wages in developing economies. But, often these wages are higher than working on the land. Supporters argue it is better to offer low paid work than no work at all.
• Free movement of labour and capital give greater flexibility to economies, for example, it can help deal with labour shortages in key areas.
Globalisation can create strong emotions, but it should be remembered that the process of globalisation is rather vague. Globalisation can be a force for good; it can also exacerbate existing problems. It depends how it is implemented.
13. Free Trade
Free trade means that there are no tariffs (tax) on imports and exports. Free trade means that it will be easier and cheaper to buy goods from abroad.
Also free trade implies removing other barriers to trade like complex forms and regulations, which increase the effective cost of trade.
In the past, countries have often put tariffs on imports making them more expensive. This is usually to protect domestic industries. For example, British farmers may complain butter from abroad is too cheap. If the government places tariffs on imports of butter, this will increase demand for British butter.
Free trade tends to be one of those topics where economists are more enthusiastic than non-‐economists.
Q. Why do economists generally favour free trade?
• Lower Prices. Removing the tariffs on imports means goods will be cheaper; this increases the living standards of consumers.
• Exporters who have a comparative advantage will be able to export more abroad. This creates jobs in these exporting industries. Comparative advantage means they are relatively better at producing it. (Lower opportunity cost)
• Free trade enables countries to concentrate on producing what they are relatively best at. For example, Saudi Arabia will concentrate on producing oil, Japan electronics, and the UK offering education and financial services. It is more efficient to concentrate on what you are best at producing, rather than trying to produce every good you might need.
• Specialisation is more efficient. If Japan specialises in electronics and cars it can have a larger scale production. This larger scale production enables economies of scale (lower average cost with increased output). For example, there is little point in Iceland having a major car industry. It won’t be efficient. It makes more sense to export fish and use revenues to buy the small number of cars they need.
• More competition is good. In the 1970s, the UK had a small number of car firms. These were relatively uncompetitive. Globalisation gives consumers greater choice, meaning domestic monopolies have to become more efficient or go out of business.
Q. Why Do People Oppose Free Trade?
1. Job Losses. Sometimes free trade may lead to highly concentrated job losses. For example, if you remove tariffs on imports of cars, a UK car firm may go out of business leading to hundreds of job losses. Therefore, the firm and workers may want to retain tariffs to protect the business and jobs.
Overall the economy would benefit from free trade and lower prices of cars. However, people won’t protest to make cars 5% cheaper. People will protest about losing their jobs. Therefore, there are often powerful pressure groups supporting tariff barriers.
Free trade often leads to structural change, which in the short term can lead to unemployment. This process of adapting to international competition can be painful in the short term and in certain areas of the economy.
2. Not Fair on Developing Economies. The theory of comparative advantage states that you should specialise in what you are relatively best at. For many developing economies this may be agricultural products (sugar, coffee, tea). However, if you just produce sugar and coffee, the economy is unbalanced. There is less possibility for growth (when incomes rise, people don’t tend to buy more food.) Also, you are subject to fluctuations in the price of sugar. A developing economy may want to promote manufacturing industries and have greater diversity.
In the short term, these new industries may be unable to compete with established multinational companies. The argument is that tariff protection gives these new industries a chance to develop.
Many developed economies had a period of tariff protection, therefore it is unfair we don’t allow developing economies the chance to have some tariff protection whilst they try and diversify their economy.
Conclusion on Free Trade
Generally, economists favour free trade. However, there may be occasions when they support specific tariffs. The case for infant industries in developing economies is one example.
However, a big problem for developing economies is that many developed economies have high tariffs on agriculture. For example, the EU, Japan and US all have high tariffs on different agricultural items. This makes it difficult for developing economies that produce and export these agricultural goods.
Free trade in agriculture would help many poor developing economies (especially those who are net exporters of food). However, there is great political resistance to removing tariff barriers in agriculture in the developed world.
World Trade Organisation (WTO)
The WTO is designed to help resolve trade disputes and promote free trade amongst members.
Q. Why is the WTO so controversial?
Arguably promoting free trade may harm developing economies. Critics argue that by supporting free trade, they place the interests of the developed economies above poorer developing economies.
Is That Fair?
Supporters of the WTO argue that promoting free trade is one of the best ways for promoting greater economic welfare, even in developing economies. They point to countries that have seen improvements in living standards through economic growth and greater trade.
International Monetary Fund (IMF)
The IMF can be seen as a global bank. It can help economies in crisis. For example, if a country has a budgetary crisis the IMF can provide a loan to help deal with the crisis. This gives investors more confidence and helps avoid liquidity crisis. The IMF can also give advice on policies necessary for an economy to develop and maintain stable economic growth.
Criticisms of IMF
When giving funds the IMF usually insist on certain criteria to be met. E.g. if a country needs to borrow money, they will insist on spending cuts, tax increases in addition to receiving a loan. Also, the IMF often insists on free market reforms such as privatisation and deregulation to make an economy more efficient. They may also insist on tackling inflation (through higher interest rates) and devaluation to restore competitiveness.
These policies are often controversial because they can lead to job losses, recession and greater inequality. Critics argue the IMF doesn’t consider the impact of their free market policies on poverty and spending on social services.
Supporters of IMF
Defenders of the IMF say that they are unpopular because they only get asked in a real crisis. When you have a budget crisis, any policy is going to be unpopular because there is no easy fix. They argue that when giving a loan, it is important to make sure that reckless borrowing is not encouraged, otherwise the problem is likely to be repeated in the future. The IMF says that it is easy for local politicians to blame an external organisation (the IMF) for the economic pain. But, in a crisis there is no real alternative.
14. Housing Market
The housing market is apparently one of the most popular topics of conversation at dinner parties. At the dinner table, there will be probably some people, secretly (or openly), very happy their house is worth three times more than when they bought it. By contrast, younger people will probably be miserable about how expensive property is, and how difficult it is to get on the property ladder.
A paradox of the UK housing market is that we know there is a shortage of housing and we would like houses to be cheaper. But, at the same time when new housing schemes are proposed, there is often strong local opposition (e.g. protect green belt land) therefore, in the UK, we rarely build sufficient houses to meet demand.
Q. Why is the Housing Market Important to the Economy?
• When house prices are rising, it increases the wealth of householders. • Rising house prices and wealth make people feel more confident to
borrow and spend (they could always sell their house if necessary) • If prices rise, some households may take equity withdrawal (re-‐mortgage
their house and take out a bigger loan so they can spend more.) • Overall, rising house prices tend to increase consumer spending and
cause higher economic growth. E.g. rising house prices in the 1980s contributed to the Lawson boom and high economic growth.
• In the 2000s, rising house prices encouraged banks to lend more, contributing to a credit bubble and bust.
Falling House Prices
• If house prices fall, the opposite happens. Consumer confidence falls causing lower consumer spending and lower growth.
• Also, when house prices fall, people and banks will experience negative equity. (People owe more than their house is worth.) This is another factor which reduces spending.
• Falling house prices frequently makes front-‐page news (just pick up a copy of Daily Mail and Daily Express). It is the biggest form of wealth and affects a large proportion of the population
Q. If house prices fall shouldn’t it be cheaper to buy and help give people more disposable income?
Yes, houses will be cheaper and this will help first time buyers. But the majority of people are already homeowners; falling prices will only help the small number who are buying for first time. Most people will feel worse off if prices fall.
Why Are UK House Prices Volatile?
UK House prices are notoriously volatile. It often seems we never remember the previous booms and busts, but we experience a repetition of past cycles.
Reasons for House Price Volatility
1. Limited Supply
When house prices rise, we can’t easily increase supply to meet demand. It takes time to build houses (especially in UK with strict planning legislation) If demand for cars increase, firms can just supply more, but when demand for houses rise, it just leads to higher prices.
2. Changing Interest rates.
A small change in interest rates has a big effect on people’s mortgage payments. If interest rates increase, people may be unable to afford a mortgage so they have to sell. Lower interest rates makes buying more attractive, increasing demand. In other countries, more homeowners choose fixed rate mortgages; therefore, they are less sensitive to interest rate changes. But, in the UK, variable mortgages are more popular and therefore changes in interest rates can significantly affect the demand and price of houses.
3. We Take Risks to Buy
Because UK house prices are so expensive, people often take out mortgages which require a big % of their disposable income. Therefore, changes in the economy can soon affect our ability to pay the mortgage.
Graph showing mortgage payments of first time buyers can take between 28% and 70% of take home pay.
4. Volatility in Mortgage Lending.
Before 2007, banks were very liberal in giving mortgages. You could get a 100% mortgage (i.e. needed no deposit), or a self-‐certification mortgage (i.e. you didn’t have to prove your income, enabling you to borrow more than you could afford)
However, after the credit crisis, banks were short of money so they became very strict in lending mortgages. When it was easy to get a mortgage, house prices rose rapidly. When it was difficult to get a mortgage, demand and prices fell.
5. Boom and Bust in Economic Cycle.
If the economy goes into recession, demand for houses will fall. When growth is high, people have the confidence to borrow more. If you fear unemployment, you won’t buy a house.
6. Speculators
Rising prices encourage people to try and make capital gains (benefit from rising prices). When prices are rising, there are more buy to let investors pushing up prices further. But, when prices fall, speculators are likely to sell their houses to prevent a fall in their wealth.
7. Poor Memories.
People often have poor memories and during a boom forget that house prices can fall. They assume that house prices will go on rising forever.
Q. Why Are UK House Prices So Expensive?
In London house prices are roughly six times average earnings. But, most banks will only lend you a mortgage three times your income.
Despite the fall in house prices between 2008-‐09, many young people still can’t afford to buy a house. In the US, Spain and Ireland, house prices fell considerably more than in the UK. Against some expectations, UK house prices didn’t fall as much as you might expect.
The quick answer is that the UK still has a shortage of housing. Demand is greater than supply and this keeps prices high.
In the boom period of the 2000s, Ireland, Spain and the US also had a boom in building houses. Higher prices encouraged firms to build more houses. In Spain they were building up to 450,000 homes a year. In the UK, we didn’t have an increase in house building. We actually built record lows of less than 150,000 houses per year.
In Spain, Ireland and US, there are many unsold houses depressing prices. The UK still has a shortage
The UK population is growing faster than we are building new homes. Unless we build more, houses prices will remain relatively more expensive than countries where supply is greater.
Q. Why Don’t we Build More Houses?
The simple answer -‐ Not in my back yard.
Most people would say it is good to build more houses to meet rising demand. However, if a new property development is proposed in their local area, typically there is strong local opposition. Opposition to new houses is based on fear of congestion, overuse of public services, and loss of green space.
There is also a monetary incentive to oppose building new houses -‐ if you don’t build new houses, it increases the value of your existing homes. If supply increases, the price will be lower. People who want to buy a new house are in the minority.
Probably the biggest opposition to house building comes from a desire to protect local communities from ‘over expansion’. It is understandable people wish to protect local green-‐belt land. But, the national effect is that we end up building fewer houses than we need.
UK Economic History
This section offers a quick look through UK economic history, showing the main trends in economic thought and how economics has affected the lives of British people.
1. Victorian Period
Economics in the mid to late Nineteenth Century was characterised by:
1. Minimal government intervention in the economy.
Victorians believed in laissez-‐faire and that generally the government shouldn’t intervene in the workings of the free market. Taken to its logical conclusion, the government refused to give free corn to Ireland, during the potato farming. Respected civil servants like Charles Trevelyan – on one occasion wrote that the Irish famine was a ‘mechanism for reducing surplus population.’ This was laissez-‐faire taken to its extreme, but it highlighted the dominant belief the government’s role must be strictly limited in the economy.
2. Free Trade debate.
During the Nineteenth Century there was a big debate between those who wanted free trade and those who wanted tariffs (often called mercantilism).
The landed aristocracy had a vested interest in tariffs on imports of corn because this kept the market price of corn high and therefore they could make higher profits. The Corn Laws restricted cheap imports of corn from 1815 to 1846.
However, the Corn Laws were bad news for the poor, working class who had to pay more for food. In the Nineteenth Century, living standards of the working class were so poor that the price of corn could make the difference between being able to buy enough food to live on and going hungry.
In 1846, the Corn Laws (tariffs on imports of corn) were repealed, leading to lower prices of food. Business owners generally supported the repeal of the Corn Laws because cheaper food was effectively a wage increase for their workers. The repeal of the corn laws was important for showing a shift in balance of power between the landed aristocracy (who benefitted from high agricultural prices) and ‘new money’ – Industrial owners who benefitted from cheaper living costs for their workers.
3. Growth of Capitalism.
The Nineteenth Century witnessed rapid economic expansion, helped by the new railways and the process of industrialisation. Output increased at a previously unheard of rate.
4. Growth of the Banking Sector.
The demands of capitalism led to a growth in the banking sector because there were greater demands for raising finance. There were quite a few spectacular booms and busts, such as the Railway mania of the 1840s.
Investors were encouraged to invest in a variety of railway schemes on the promise of big dividends, but these schemes were often over-‐optimistic and investors lost everything. However, the growth of a new industry like the railways was important in the development of modern banking (and the stock market) because there was much greater demand for finance, which banks and the stock market could provide.
5. First Government Regulations.
The growth of Capitalism, led the government to grudgingly, unwillingly and hesitantly accept the necessity for some basic laws and regulations. Conditions in factories were often so bad that campaigns were mounted and some laws were introduced to protect workers. There was a growing realisation that the free market did need a degree of regulation and state intervention.
2. Liberal Capitalism 1900-‐1914
The election of the Liberals in 1901 marked the start of a new approach to Capitalism. Faced with the growth of trades unions and an increasingly organised working class, the government responded by introducing the first signs of a Welfare State. In the ‘People’s Budget’ of 1909, the Chancellor Lloyd George (with strong support from Winston Churchill) introduced the first pension (for people over 65) and the first type of unemployment insurance. It was partly financed by higher income tax on the rich.
The Welfare State was still patchy, but the principle of government aid to less fortunate members of society was established. At the time, the idea of redistributing wealth was quite controversial. Lloyd George said in his speech to the House of Commons.
“This is a war Budget. It is for raising money to wage implacable warfare against poverty and squalidness…”
The radical nature of the budget, led the House of Lords to oppose it. This precipitated a constitutional crisis, with the House of Commons eventually asserting its political supremacy over the Lords to get the bill passed.
3. First World War
One consequence of the First World War was a huge growth in the size of government intervention in the economy. During the war, the government increasingly micro-‐managed every aspect of the economy. Government spending increased drastically, leaving the UK with a huge public sector debt of over 180% of GDP (more than double todays debt) At the end of the First World War, women had become involved in the economy in a way never previously known.
Also, after the end of the First World War, there was a rapid growth in trade unions and the power of organised Labour. This was illustrated by the Labour party gaining their first taste of political power in the short-‐lived 1924 coalition.
4. Gold Standard in the 1920s
Paris and New York may have been thriving during the Jazz age of the 1920s, but for the UK, the 1920s was a period of high unemployment, slow growth and steady decline in the relative size of Britain’s economy.
A key issue was the government’s decision to re-‐join the gold standard and fix the price of Pound to $4. The gold standard meant the value of Pound Sterling was fixed. However, the UK’s economy struggled with this high exchange rate. After the war, UK manufacturing became increasingly uncompetitive, leading to lower demand for exports and unemployment. The sluggish growth led to a prolonged period of deflation (falling prices). This deflation, led to even lower spending and rising debt burden harming economic growth.
5. 1930s Great Depression
Already facing high unemployment, the UK economy was swept up in the events of the stock market crash of 1929 and the subsequent Great Depression. The UK was a relatively open economy, relying on exports for a considerable part of the economy. The global slowdown led to a fall in exports, leading to lower growth and higher unemployment. This led to a negative multiplier effect, with the unemployed spending less and leading to even higher unemployment.
1931 Budget By 1931, the UK economy was in a serious recession, unemployment had reached close to 15%, and as a consequence government borrowing had increased. The Treasury economists told the Labour government, they must balance the budget by increasing taxes and cutting spending. The Labour Prime Minister, Ramsay McDonald agreed to these policies, but most Labour MPs didn’t accept the budget, McDonald formed a National government, composed mostly of Conservative MPs.
The spending cuts and higher taxes, combined with a fall in global trade made the recession worse. It led to a prolonged period of high unemployment, especially in the north and industrial areas.
It was in the 1930s, that J.M. Keynes wrote his general theory of money and argued for increased government borrowing and spending to boost economic activity. However, in the 1930s, his ideas were largely ignored and the UK remained stuck in recession with high unemployment. From 1936, the UK economy did recover to some extent. Leaving the gold standard in 1931 helped, and there was something of a boom in house building in the late 1930s, especially in the new suburbs of the South East; but the mass unemployment remained until the outbreak of the Second World War.
6. 1945-‐ 1970s Post War Prosperity
In 1945, the UK had triumphed in its war aims, but the economy was broke. In the post war period, public sector debt stood reached over 200% of GDP, and there was a necessity for rationing to remain.
Welfare State
Despite the record debt levels, the 1945 Labour government still managed to set up the basic framework of the Welfare State. The NHS and a comprehensive system of social security was quite an achievement given the perilous state of the nations finances.
During the War, a liberal politician William Beveridge had outlined a manifesto for eliminating want and poverty. This included a Welfare State and commitment to full employment. This Beveridge Report captured the imagination of the public and was a factor in helping Labour’s shock election victory in 1945.
Nationalisation.
In the 1940s, the government nationalised many key industries. Some of these like the railways were broke anyway; government nationalisation was necessary to keep them going. But, other industries were nationalised due to ideology -‐ the idea that key industries should be managed in the public interest rather than purely for profit.
Post War Boom.
Like other European economies, the UK benefited from a prolonged period of economic expansion. In the post-‐war era, there was a period of full employment, strong economic growth and rising living standards. Also, it was a period of rapidly falling inequality. For the first time the benefits of capitalism were being equally shared. Compared to other developed economies, the UK lagged behind; our growth and productivity were less than our competitors. This was reflected in a depreciation in the value of the pound. But, given the overall rise in living standards, a relative decline didn’t seem so important.
7. 1970s Economic Instability
Up until the 1970s, the UK had avoided both high inflation and high unemployment. Full employment and rising GDP were key factors in keeping the welfare state affordable. The welfare state was so popular, it was largely accepted by the Conservatives. Even the nationalisation of key industries was generally accepted. There appeared to be a new post-‐war consensus based around a mixed economy, welfare state and commitment to full employment.
The oil price shock of 1973 was a serious blow to this post-‐war consensus. Although the UK was less dependent on oil imports than other economies, the tripling of oil prices caused a sharp rise in inflation. Combined with powerful trades unions bargaining for higher wages to compensate, the UK experienced a volatile and higher inflation rate. In 1974, partly as a result of the oil price shock, the UK plunged into its first real recession since the Great Depression. The recession was relatively short lived, but it didn’t solve the underlying inflationary problems. There was also concern over the state of UK industry; a record number of hours were lost to strikes. There was a real feeling of deep-‐seated confrontation between workers and employers. Key UK industries like British Leyland became the butt of jokes for their poor reliability. The government felt compelled to subsidise industries like British Leyland to keep it from going bankrupt. But, government subsidies seemed to do nothing to improve productivity and change its fortunes.
8. The 1980s – The Thatcher Revolution
In 1979, the UK had persistently high inflation, poor productivity growth, confrontational trade unions and a weak economy. But, few could have predicted how radically the incoming Conservative party, headed by Mrs Thatcher, would change the economy. Key elements of Thatcherite economics included:
Monetarism.
A key tenant of Mrs Thatcher’s early economic policy was to control inflation. To monetarism, the control of inflation through controlling the money supply was the key to long-‐term sustainable growth. Monetarism witnessed renewed interest in the 1970s, helped by Milton Friedman and the apparent breakdown of the post war Keynesian consensus. Also, the Monetarist ideology of less government intervention appealed to politicians like Reagan and Thatcher.
In 1980, Monetarist policies in the UK saw a rapid increase in interest rates, higher taxes, and lower government spending. This led to a fall in inflation and negative economic growth. Due to the discovery of more oil in the North Sea, there was also a rapid appreciation in the value of Sterling during 1979-‐1980. The Pound surged in value, but this made UK exports less competitive. The impact of these policies on UK manufacturers was devastating. There was a deep recession, especially in the manufacturing heartlands. This led to unemployment rising to 3 million – a level not seen since the great depression.
U-‐Turn if you want to In October 1980, as the recession began to bite and under great political pressure, Mrs Thatcher, stood up at the Conservative party conference, and said ‘You turn if you want to. The lady's not for turning.’ The conference loved it; it was excellent politics, though the economic reality was that unemployment would continue to increase and would remain close to 3 million until 1985-‐86.
In 1981 recession, 365 economists wrote a letter to the Times, saying the government should change its policy and try and stem the rise in unemployment. But, economic policy didn’t change. The government made it clear that it considered the control of inflation to be a higher priority than achieving full employment. Eventually, the economy did recover with low inflation, but it was at a high social cost of rising youth unemployment – a contributory factor to social unrest and riots, which marked UK inner cities in 1981.
Miner’s Strike 1984 In 1974, the coal miners strike arguably helped defeat Ted Heath’s government. In the 1970s, mining unions had reduced the UK to a three-‐day week. To Mrs Thatcher there was unfinished business; she wanted to tackle the power of trades unions for once and for all. She didn’t see why the country should be held to ransom by a ‘Communist’ such as Arthur Scargill. After an exceptionally bitter one-‐year strike, the government effectively won. It marked a turning point in UK industrial relations. Trades unions were fundamentally weakened by both the economic and political changes of the 1980s. Organised labour has never returned to the levels of influence they had in the 1970s.
Privatisation During the 1980s, many nationalised industries were privatised. These industries included BP, British Telecom, Water, and Electricity. They were sold by floating the new company on the stock market. Many people benefitted from buying shares at a discounted price and selling them at a higher price. To critics, privatisation was a cynical political exercise to buy short-‐term popularity by selling key industries at a lower cost than they were worth. To supporters, privatisation was a necessary policy to make nationalised giants face the rigours of the free market. Defenders of privatisation argue that in the private sector, firms had much greater incentive to be efficient, cut costs and be more productive.
The reality was probably a mixture of the two. The privatised industries were sold cheaply, but after privatisation some industries did show gains in productivity and efficiency. However, some industries, such as railways, were much more difficult to privatise and arguably led to higher prices for consumers, with limited gains in service quality.
Inequality One feature of the 1980s was a rapid rise in inequality. This was partly due to the rise in unemployment, and also the growth in wage inequality. The decline of manufacturing led to the loss of many relatively high paid unskilled jobs. But, in the service / financial sector, wages soared.
The Gini Coefficient is a measure of inequality. A higher number shows increased inequality.
Lawson Boom In the late 1980s, the UK economy grew at a record level. After lagging behind our international rivals for most of the post-‐war period, in the late 1980s, the UK economy expanded at one of the fastest rates in the world. The government claimed vindication for its supply side policies which they claimed had revitalised a moribund economy. The government argued that, freed from the shackles of nationalisation, powerful unions and support for inefficient state owned industries, the UK economy could grow at an unprecedented rate.
The second half of the 1980s was a period of tremendous enthusiasm and confidence. House prices rose at record levels, reaching an annual growth rate of over 35%. Even a 25% stock market crash in 1987 failed to derail the economy.
However, hopes of an increase in the long run average growth rate proved unfounded. The growth was too fast and inflationary pressures started to increase, reaching close to 10% by 1989. Rather belatedly, the government realised inflation was starting to become out of control. To try and control inflation, the chancellor, Nigel Lawson, persuaded the government to enter the exchange rate mechanism (ERM) a policy of fixing value of pound to DM (a precursor to the Euro) Joining the ERM necessitated higher interest rates to keep the value of the pound at its target level and to reduce inflation.
Source: of base rate Bank of England series IUMAAMIH
However, the drastic increase in interest rates proved to be devastating for homeowners who struggled with their mortgage payments, which now shot through the roof. As interest rates increased, house prices fell. This combination of higher interest rates and falling house prices caused the recession of 1990-‐01. Unemployment once again rose to 3 million.
Despite the depth of the recession, the government were committed to keeping the Pound in the ERM. However, to keep the Pound at its target level against the D-‐Mark, interest rates had to be kept very high. This strangled any hope of recovery. Market investors felt the government were making a mistake and it wasn’t possible to keep the Pound at such a high level – given the state of the economy. Investors sold Sterling, and the government used its foreign exchange reserves to buy Sterling to try and protect the value of the currency. However, on Black Thursday, October 1992, the government finally admitted defeat and left the ERM. However, by leaving the ERM, interest rates were reduced and the economy could recover.
9. 1993-‐2007 The Great Moderation
After this boom and bust, the government tried to prevent future inflationary boom and busts. An important change was that The Bank of England were given independence to set interest rates; they were instructed to target an inflation rate of 2.5% (now CPI 2%). The idea was that the Bank of England would avoid the political pressure to cut rates before an election. It was also hoped that an independent Central Bank would have greater credibility in keeping inflation low.
After the 1992 recession, the UK experienced the longest period of economic expansion on record. Yet, despite the prolonged growth there was no resurgence in inflation. In fact, inflation remained very close to the government’s target of 2%. There were quite a few who felt we deserved a degree of self-‐congratulation for breaking the boom and bust cycle and delivering sustainable low-‐inflationary growth. It did appear the Bank had been able to prevent inflationary booms, which the UK had seemed so susceptible to in the past.
Yet, behind this ‘great moderation’ was a different type of boom and bust, which was largely ignored or given little attention. This was a different kind of boom. It was a boom in bank lending and rise in asset prices. It was a period where banks took on more lending and more risk. But, these levels of lending later proved to be unsustainable.
In the 1980s, many building societies were de-‐mutualised and become private banks listed on the stock market. This changed their behaviour -‐ the new banks sought to make ever-‐greater profits; former building societies like Northern Rock and Bradford & Bingley became among the fastest growing lenders. To
lend more mortgages, they would borrow money on money markets. Effectively they were borrowing money at a low interest rate and lending this borrowed money at a higher interest rate.
This was fine until the global credit crunch. Suddenly banks could no longer borrow from money markets, to finance their lending. This meant banks like Northern Rock suddenly found themselves short of liquidity (cash) and ultimately required a bailout by the government.
The difference in the past was that building societies lent money they attracted in savings. Therefore, building societies were not dependent on global money markets. But, in the new era of deregulated banking, banks were also lending money that they had borrowed. This enabled them to make more profits in the boom years, but it left them exposed with big holes in their balance sheets when they could no longer borrow.
Q. Why were banks so reckless in lending money they didn’t have?
It is always easy to be wise after the event. But, it is worth trying to understand why banks acted like they did.
1. For quite a few years, it was profitable. Banks felt they had a duty to maximise profits for their shareholders, and increasing the quantity of lending was a method to do this.
2. Higher profit meant higher bonuses. A lot has been written about bank bonuses, not always favourably. But, if banks made higher profit, the directors were often in line to receive million pound performance related pay. There was a clear financial incentive to seek higher profit.
3. Belief in stability. In the past, instability came from inflation. But, with inflation low and economic growth positive, there were reasons to believe that we were experiencing a sustained period of economic expansion and economic stability. And, to some extent we were, 1993-‐2008 was the longest period of economic expansion on record.
4. Era of low interest rates. With inflation seemingly tamed, it enabled much lower long-‐term interest rates which made borrowing more attractive.
5. Belief in rising house prices. Although house prices rose to record levels and the ratio of house price to incomes increased, many felt these levels were still sustainable.
6. Belief in the free market. The 1980s and 1990s saw a process of financial deregulation. It was felt that the government were incapable of regulating the financial sector, and anyway it was better to leave it to the free market.
7. Global competition. Globalisation meant that it seemed easy to attract capital from around the world. Therefore, it seemed that one of the benefits of globalisation was different rules – and an ability to lend more than previously.
10. 2008 -‐ 12 Recession
In 2008, the UK entered recession because:
• After the credit crunch, banks radically reduced lending, leaving business short of funds for investment.
• Higher oil prices reducing living standards and disposable income • Falling house prices leading to lower household wealth and lower
spending. • Fall in exports due to global economic downturn. • Fall in confidence over bad economic news. • Rise in saving ratio as people tried to pay off debts.
Because of the depth of the fall in GDP, interest rates were slashed to 0.5% by March 2009. This was a record low, but even these record low interest rates failed to bring about a quick economic recovery.
This was a different recession to 1981 and 1991. In the previous recessions, the fall in demand had been caused by a rise in interest rates or rise in value of pound. When these were reversed, the economy could recover.
But, in 2008-‐11, the recession was caused by fundamental problems in the banking sector. Cutting interest rates couldn’t reverse the fall in demand.
• The whole banking sector was short of liquidity and so didn’t want to lend.
• Lower base rates didn’t really help because banks were unwilling to lend, even if people wanted to borrow.
Why Did the Recession of 2008-‐12 Last So Long?
1. Debt Deleveraging. In 2008, total UK private sector debt was high. After the credit crunch banks and individuals sought to reduce their debt burdens by cutting bank on bank lending and spending less. But, to reduce debt burdens can be a long process. In 2012, the UK still had one of the highest combined debt levels (public debt + private debt) of 400% of GDP (McKinsey report on Debt deleveraging, Jan 2012)
2. Declining Living Standards. Despite the fall in economic output, we also experienced inflation. This inflation was due to cost-‐push factors such as:
• Impact of devaluation increasing the price of imports. • Rise in price of petrol, food, energy and other commodities • Rise in taxes (e.g. VAT increase)
Therefore, with a decline in real incomes, it is inevitable consumer spending was reduced.
3. Government Austerity. There was a partial economic recovery in 2010. However, after being elected the Conservative / Lib Dem coalition made plans to reduce the size of the UK’s budget deficit. They claimed that the Euro debt crisis meant it was necessary to reduce government borrowing quickly, therefore the government cut spending and increased taxes. Whether it was necessary to act so quickly or not is uncertain. But, the attempts to reduce government borrowing led to lower aggregate demand contributing to a double dip recession in 2011-‐12.
4. Lower Interest Rates Didn’t Work. Usually interest rates of 0.5% would boost spending investment and encourage people to buy a house. But, in the recession of 2008-‐12, banks didn’t want to lend at these low interest rates. Therefore, even though it was theoretically cheap to borrow, in practise it was difficult.
5. UK Badly Hit by Decline in Financial Services. The recession directly affected the financial service sector. This is one of the UK’s most important industries and a key source of government tax revenue. Because of the impact on financial services, the UK economy was adversely affected more than others.
European Debt Crisis
In 2007, EU economies, on the surface, seemed to be doing relatively well – with positive economic growth and low inflation. Public debt was often high, but (apart from Greece) it appeared to be manageable -‐ assuming a positive trend in economic growth. For example, in 2007.
Spain’s debt to GDP ratio – 37%
Ireland’s debt to GDP ratio – 27%
Japan by contrast had a debt to GDP ratio of 220% of GDP. Few would have predicted that Europe would soon have a debt crisis.
However, the global credit crunch changed many things.
• Bank Loses. During the credit crunch, many commercial European banks lost money on their exposure to bad debts in the US (e.g. subprime mortgage debt bundles which became worthless)
• Recession. The credit crunch caused a fall in bank lending and investment; this caused a serious recession. The recession led to a fall in tax revenues and required higher government spending on benefits. Therefore, European governments saw a rapid rise in their budget deficits.
• Fall in House Prices. The recession and credit crunch also led to a fall in European house prices, which increased the losses of many European banks. This was particularly damaging for a country like Spain which had seen a boom in house building in the boom years.
Graph showing the scale of European Recession.
Problems of Recession and Debt
The European recession caused a rapid rise in government debt. The recession caused a steep deterioration in government finances. When there is negative growth, the government receive less tax.
• Fewer people working = less income tax; fewer people spending = less VAT; smaller company profits = less corporation tax etc.)
• The government also have to spend more on unemployment benefits.)
Also, as well as falling tax revenues, falling GDP means the debt to GDP ratio will rise more rapidly.
• For example, between, 2007 and 2011, UK public sector debt almost doubled from 36% of GDP to 62% of GDP.
• Between 2007 and 2010, Irish government debt rose from 27% of GDP to over 90% of GDP.
EU Bond Yields
During the early 2000s, markets had assumed Eurozone debt was safe. Investors assumed that with the backing of all Eurozone members there was an implicit guarantee that all Eurozone debt would be safe and therefore there was no risk of default. Therefore, investors were willing to hold Eurozone debt at low interest rates even though some countries had quite high debt levels (e.g. Greece, Italy). In a way, this perhaps discouraged countries like Greece from tackling their debt levels. (They were lulled into false sense of security by low interest rates)
However, after the credit crunch, investors became more sceptical and started to question European finances. Looking at Greece, they felt the size of public sector debt was too high given the state of the economy. People started to sell Greek bonds, which pushed up interest rates.
Unfortunately, the EU had no effective strategy to deal with this sudden panic over debt levels. It became clear the German taxpayer wasn’t so keen on underwriting Greek bonds. There was no fiscal union and investors realised that Eurozone countries could actually default. It was very difficult for the EU to agree on any comprehensive debt bailout. There was a real risk of debt default. Therefore, markets started selling more – leading to higher bond yields.
No Lender of Last Resort.
Usually, when investors are reluctant to buy bonds and it becomes difficult to ‘roll over debt’ – the Central bank of that country intervenes to buy government bonds. This can reassure markets, prevent liquidity shortages, keep bond rates low and avoid panic. But, the ECB made it very clear to markets it will not do this. Countries in the Eurozone have no real lender of last resort. Markets really dislike this as it increases the chance of a liquidity crisis becoming an actual default.
For example, UK debt rose faster than many Eurozone economies, yet there has been no rise in UK bonds yields. One reasons investors are currently willing to hold UK bonds is that they know the Bank of England will intervene and buy bonds if necessary.
Contagion
After Greece saw rapid rises in bond yields, investors began to examine all countries in the Eurozone. There was a knock on effect with investors becoming generally more sceptical about Eurozone debt. All countries in Eurozone became much more closely scrutinised. Quite quickly many European countries saw a rapid increase in bond yields – Ireland, Portugal, Italy, and Spain.
Un-‐Competitiveness in the Euro.
Eurozone countries with debt problems are also generally uncompetitive with a higher inflation rate and higher labour costs. This means there is less demand for their exports. This decline in demand for exports leads to lower economic growth. Because they are uncompetitive this leads to a large current account deficit and lower economic growth. (The UK became uncompetitive, but being outside the Euro, the Pound could depreciate 20% in 2009 restoring competitiveness. In the Euro, countries can’t devalue to restore competitiveness. Thus, they face a continued decline in domestic demand.
Poor Prospects for Growth
People have been selling Greek and Italian bonds for two reasons. Firstly, because of high structural debt; but, also because of very poor prospects for economic growth. Countries facing debt crisis have to cut spending and implement austerity budgets. This causes lower growth, higher unemployment and lower tax revenues. However, countries with debt crisis have nothing to stimulate economic growth.
• They can’t devalue the exchange rate to boost competitiveness (they are in the Euro)
• They can’t pursue expansionary monetary policy (ECB won’t pursue quantitative easing, and actually increased interest rates in 2011 because of inflation in Germany)
• They are only left with internal devaluation (trying to restore competitiveness through lower wages, increased competitiveness and supply side reforms. But, this process of internal devaluation can take years of high unemployment and low growth.
Paradox of Austerity and Higher Bond Yields.
It is a paradox that markets see high debt levels and call for spending cuts. These temporary spending cuts please the market, but as a result of spending cuts, the economy goes into recession leading to lower tax revenues and higher debt. This makes it difficult to reduce debt to GDP (and also leads to calls for more austerity). Olivier Blanchard of IMF writes:
They react positively to news of fiscal consolidation, but then react negatively later, when consolidation leads to lower growth—which it often does. (2011 in Review: Four Hard Truths)
Individual Cases
Ireland
Ireland’s debt crisis was mainly because the Irish Government had to bailout their own banks. The bank losses were massive and the Irish government needed to inject billions into the commercial banks. However, combined with a collapse in tax revenues from the recession, Irish government debt rose too quickly. The Irish government then needed a bailout. (In a way it was a bailout to pay for the bank bailout)
Greece
Greece had a very large debt problem even before joining Euro and before the credit crisis. The credit crisis exacerbated an already significant problem. The Greek economy was also fundamentally uncompetitive – reflected in a large current account deficit and low growth. Attempts to reduce the budget deficit led to a significant fall in output and even lower tax revenues.
Italy
Italy’s debt crisis was due to a combination of long-‐term structural problems, such as failure to collect tax revenues. Italy also had very weak growth prospects and a legacy of political instability.
Summary of Main Causes of Debt Crisis
• High structural debt before crisis. Exacerbated by ageing population in many European countries.
• Recession causing sharp rising in budget deficit. • Credit crunch caused losses for commercial banks. Therefore, after credit
crunch, investors became much more cautious and fearful of default in all types of debt.
• Southern European economies were uncompetitive (higher labour costs) but couldn’t devalue to restore competitiveness. This causes lower growth and lower tax revenues in these countries.
• No lender of last resort (like in UK and US) makes markets nervous of holding Eurozone debt because they can easily experience liquidity crisis.
• No effective bailout for a country like Italy. • Fears of default raise bond yields, but this makes it much more expensive
to pay interest on debt, e.g. cost of servicing Italian debt has risen meaning they will have to raise €650bn ($880bn) over next three years. It becomes a vicious spiral. Higher debt leads to higher interest rate costs making it more difficult to repay.
• It’s very difficult to leave the Euro. • Unfortunately, the solutions to the debt crisis have often been self-‐
defeating. For example, faced with large budget deficit and rising bond yields, countries have pursued ‘fiscal austerity’ – spending cuts and higher taxes. However, this causes lower growth. The lower economic growth creates a negative spiral of falling tax revenues, higher unemployment and higher borrowing.
• The solution to the Euro debt crisis requires more than just spending cuts. It also requires: 1. Policies to increase economic growth and reduce unemployment 2. Policies to restore competitiveness due to overvalued exchange rates
Why do Economists Disagree so often?
Economics tries to deal with facts, but there can be many different interpretations of the same data. Firstly, economists do agree over many things, but there can also be severe disagreement even amongst Nobel-‐prize winning economists.
Examples of Disagreement
1. Importance of Low Inflation
Let us take the example of CPI inflation rising to 4.5% in 2011 (above the governments target of 2%) During this period, unemployment was high and economic growth low.
In general economists will all agree that:
• CPI Inflation is 4.5% • Inflation is potentially damaging to the economy • Monetary Policy (interest rates) should generally be used to keep
inflation low
However, there were two different suggestions on what to do next.
1. Increase Interest Rates. Inflation is well above target; therefore the Central Bank should increase interest rates to keep inflation on target. If the Bank doesn’t increase interest rates then they will lose credibility for keeping inflation low. Also if they allow inflation to persist it will lead to higher inflation expectations in the future, and this cost-‐push inflation can become permanent.
2. Keep Interest rates low. Although inflation is above target, it is actually due to temporary factors (rising oil prices, rising taxes). Therefore, the Bank shouldn’t increase interest rates because core ‘underlying’ inflation is actually low. Also if they increase interest rates it could push the economy back into recession. Therefore, although inflation is above target, it is more important to worry about unemployment and economic growth.
Both points of view offer reasonable economic analysis. The difference stems from:
• Which is more important low inflation or low unemployment? • Is the inflation permanent or temporary? • Will this temporary inflation increase future inflation expectations?
In 2011, the ECB increased interest rates in response to the cost push inflation. By contrast, the Bank of England kept interest rates at 0.5% -‐ despite inflation in the UK being much higher. This shows how Central Banks can take different responses to the same situation.
2 Do Tax Cuts Increase Tax Revenues? A popular economic argument amongst free market economics is the idea tax cuts can increase incentives to work. Some even suggest tax cuts can actually increase tax revenue.
For example, if income tax was set very high at say 70%, people may feel no incentive to work. They may even leave and work in another country with a lower tax rate.
Therefore, if you cut income tax, the argument is that people will be more willing to work. Therefore as more people work, the government’s tax revenue may actually increase, even though the tax rate is lower.
There was an economist called Laffer. He reasoned that if there was a tax rate of 100%, the government would get no tax. If the tax rate was 0%, the government would also get no tax. Therefore, they must be a tax rate at which revenue is at a peak.
Therefore, he claimed in many cases a tax cut could increase government revenues. This idea of cutting taxes and getting more revenue obviously appealed to quite a few politicians!
However, the other point of view states in the real world, a cut in income tax is not guaranteed to make people work.
• Suppose you have a target disposable income of £20,000 a year which you need to pay your bills and buy everything you need.
• A cut in income tax means it is easier to earn this target of £20,000 disposable income. You can actually work less to gain your target income.
• If income tax increases, the average worker is unlikely to be able to cut back on hours. They may even feel they need to work longer hours to gain enough income.
Whether High Tax rates reduce incentives depends on quite a few factors
Only the very rich will tend to consider moving country to avoid high rates of tax. The average worker can’t relocate to Jersey because income tax has increased from 21% to 23%. But, for a millionaire, it may be worth moving. The tax saved is greater than the cost of relocating.
Also it depends on the rate of income tax. In post war Britain, the highest income tax rate was 87%. Clearly this was a very dramatic tax which did make work look unattractive for high-‐income earners. At this kind of rate, there is a strong disincentive to work.
But, if you increase the higher income tax rate from 40-‐50% it is more uncertain whether people will reduce their hours.
Arguably, globalisation means that high tax rates have a greater impact on disincentives than 50 years ago. In the late 1940s, it wasn't so practical to go and live abroad to avoid paying taxes. But, in the Twenty First Century, it is much easier.
Frequently asked Questions
Some of these questions have already been answered in this economics help guide. But, as they get asked so frequently, I’ll put them in their own section here.
Q. Who Does the UK Owe Money To?
The UK government has borrowed from the private sector by selling bonds. These are bought by a variety of financial bodies such as pension funds, investment trusts and banks. Foreign banks may buy about 25-‐30% of these bonds. But, mostly, the government owe money to individuals and bodies in the UK.
Q. How much do we (UK) Owe?
When people ask how much do we owe, they usually mean how much does the government owe?
The official level of UK public sector debt is just over £1,004bn (start of 2012) or 64% of GDP. But, by the time you read this, it will be higher.
There are other measures of government debt, for example, if you include liabilities from financial sector intervention, UK public sector debt is much higher at over £2,200bn. However, the government hopes to reclaim a good proportion of this financial sector intervention after selling shares in nationalised banks.
We could also look at total UK debt. This includes private debt + government debt. Private debt includes (mortgage debt, personal loans, credit card debt, corporate debt). Total UK debt is around 400% of GDP. This is one of highest levels in the developed world.
To confuse things there is also something known as external debt. This is the money we owe to people in other countries. It is mostly banking liabilities. Note, the Government only contributes a small amount to external debt. External debt is around £6,000bn or 500% of GDP. However, we also have external assets of around £6,000bn. As long as our assets (investments abroad) don’t devalue, it’s not quite as bad as it sounds. But, high external debt can potentially cause problems.
Q. Why does the government borrow to try and deal with the problems of debt?
It is true bad debts did cause the credit crunch of 2008, and this led to the recession of 2009. However, in a recession, consumers often rapidly increase their savings causing a sharp fall in consumer spending. This leads to lower economic growth. Therefore, the government borrow to offset this rise in private sector saving. Through government borrowing, they aim to maintain aggregate demand and limit the fall in GDP. If the government cuts its deficit in a recession, there would be a fall in consumer spending and also fall in government spending causing a more significant fall in growth.
Q. Why doesn’t the government subsidise firms to develop new technology, which improves the economic growth rate?
There may be a case for the government subsidising some technologies which have a potential benefit for society and would be underfunded in a free market. For example, solar power energy could provide carbon free energy. Solar power has a strong positive externality because it helps to reduce pollution and global warming. However, it is important to bear in mind, most technological improvements in an economy tend to come from the private sector. The government has a poor track record of picking technological winners (apart from in times of war). There is only a limited role the government can play in creating technological advances. However, if a good has a high positive externality (benefit to third party), then in theory government subsidy can help to overcome the market failure of under-‐consumption in a free market.
Q. Does printing money cause inflation?
Yes, printing money does usually cause inflation. Printing money leaves national output the same. However, with more money chasing the same number of goods. Firms will respond by pushing up prices. Let us assume due to printing money there is a 100% increase in the money supply. The amount of cash people has doubles. However, the amount of goods stays the same. In that case the price of these goods will just increase 100%. Printing money has not created output, only caused things to be more expensive.
Monetarist theory suggests there is a strong link between the money supply and inflation. If you increase the money supply, prices will increase.
Q. Can you Print Money Without Causing Inflation?
Yes, it is possible. In a deep recession, this link between printing money and inflation can be broken. A short explanation is that in a recession, banks and consumers may just hoard (save) this extra money. Therefore, although there is an increase in notes and coins, the frequency with which they change hands declines.
Monetarist theory states inflation is linked to money supply by this formula
MV=PY (M – money supply. P=Price Level, V= Velocity of circulation, and Y = output)
Monetarist theory assumes V and Y are stable. But, in practise they may not be.
If velocity of circulation falls, you may need an increase in the money supply to prevent prices falling.
When the Bank of England created money through quantitative easing. They increased the money supply and bought bonds from commercial banks. Banks saw an increase in their bank reserves. Usually, they would lend this out and this extra lending could cause inflation. But, in a recession, banks just kept the money and improved their balance sheets. Therefore, there wasn’t inflation.
Q. Could Printing Money Create Delayed Inflation?
In a recession, the extra money is saved and so inflation does not occur. However, over time, the economy could recover, and the extra money could cause inflation unless the Central Bank can adequately reverse its increase in the money supply. But, there are no hard and fast rules. It depends on many different factors.
Q. Why do Rising Commodity prices create a dilemma for Monetary Policy?
Rising commodity prices increase inflation, but they also reduce disposable income leading to lower economic growth.
The Bank of England faces an inflation target of 2%, but they also try to maintain strong economic growth.
If inflation rises above target (due to rising commodity prices), then the Bank will feel they need to increase interest rates. But, on the other hand, slower economic growth means they might want to cut interest rates to increase economic growth.
It is very difficult for the Bank of England to tackle the twin problems of inflation and slower economic growth at the same time. To some extent, they have to choose whether to accept higher inflation or lower economic growth.
Q. Why does the threat of a Credit Rating Downgrade push up Government Bond Yields?
A credit rating is an evaluation of how reliable government borrowing is. If markets have perfect faith the government will repay all its debt, they will get an AAA credit rating. This means they are safe. If people feel bonds are a safe investment, they will accept a low interest rate in return for the safe investment.
However, if markets feel a government is borrowing too much, there is a greater chance of defaulting on debt. Then they may get a credit rating downgrade (e.g. BBB). This means there is a risk of default.
If you think a government is risky, then you will want a higher interest rate on bonds to compensate for the risk of losing your investment.
A credit rating downgrade tends to be bad news for a government because it means it will be more difficult and expensive to borrow.
Q. Why Do Manufacturers complain about a strong pound?
A large proportion of manufacturing output is exported. A strong pound means that the foreign price of UK exports will be higher. This makes it more expensive for foreigners to buy British goods. Therefore, exporters will struggle to remain competitive and sell their exports.
Q. Why Can Low Interest Rates fail to boost economic growth?
In theory, low interest rates should boost economic growth. Lower interest rates make it cheaper to borrow and should encourage investment and spending. However, in practise, people may not want to spend and invest – even though it is cheap to borrow. People may have low confidence and so continue to save.
This leads to low growth and economic stagnation. Also, interest rates may be low, but if banks are short of liquidity, they won’t make funds available for lending, i.e. it might be cheap to borrow, but the quantity is limited.
Q. Is the World Economy Going to Collapse?
There have always been people predicting the imminent collapse of the world economy ever since people could conceptualise economics. The world may experience prolonged recession, inflation and debt crisis. But, it also has certain resilience. Crises have a habit of being temporary. The real challenge is to minimise the pain of these crisis, and prevent recessions become prolonged, such as in the 1930s.
Microeconomics
Q. What is the invisible hand in economics?
It sounds like a conjuring trick, but this was an important idea popularised by Adam Smith a great Scottish economist. Adam Smith observed that in an economy, the market would be very good at setting prices and producing enough goods that people wanted. He termed it the invisible hand because there is no actual agency fixing prices. It just happens by the combination of market forces
• For example, if coffee becomes more popular the demand rises. • In the short term, firms may not have enough coffee to meet the demand.
Therefore they can put up the price. The higher price moderates demand • The stronger demand and higher price encourages firms to supply more.
As firms supply more the price falls back down. • This is a simple example of how market forces respond to changes in
consumer demand.
The invisible hand can sometimes work very quickly. In 1999, VHS tapes were outselling DVDs. However, a few years later, VHS tapes had virtually vanished from the shops as firms responded to consumer demand and produced DVDs.
Q. Why are diamonds more expensive than water, when water is more essential to life?
Economics can sometimes create a seemingly perverse situation. Why do we pay £1,000 for a diamond, yet tap water is only valued at £0.01 per litre?
• Firstly, we buy a lot more water than diamonds during our lifetime. We may only buy one or two diamonds, yet we buy water every day. In our lifetime our total spending on water will be greater than diamonds.
• The second factor is the supply. The supply of diamonds is very limited. You can collect rainwater in your back garden. You can’t dig up diamonds in your back garden. Therefore, because there is a real shortage of diamonds, firms can charge a high price.
• If diamonds were as prolific as pebbles on a beech, they would be as cheap as tap water.
• A third factor is something called marginal utility. If you buy one diamond you may be very happy (in economics we say it gives a high utility).
• However, the second diamond will give less satisfaction. (it gives a lower utility). If we have a hundred diamonds, the 101st will give relatively little increase in utility.
• However, with water we need it every day. Therefore, it is giving us the same utility every day. If we got a diamond every day, we would soon get bored with the experience.
• Therefore, we are willing to pay a huge sum for a diamond wedding ring, but we won’t be buying one every week. With water we will want to buy every day. In our lifetime, our total spending on water is greater than diamonds because of the quantity consumed.
• To summarise, diamonds are expensive because they are very limited in supply. We are willing to pay such a high price for a very small number. Water is low in price because supply is plentiful, but we frequently buy it throughout our life.
Water is more important to us than diamonds, but we still end up paying much more for a diamond than a bottle of water. However, if you were in desert dying of thirst, you would probably be willing to sell all your diamonds for a glass of water. This shows how scarcity can suddenly change the price of a good.
Q. Why does the government like increasing tax on cigarettes and fuel?
Two reasons:
1. Negative externalities of fuel (social cost higher than private cost) 2. Demand is inelastic (if price increases, demand falls very little)
The government can claim that driving imposes costs on the rest of society – higher congestion levels, pollution and accidents. Smoking imposes costs on the nations’ health and increases the NHS costs. A tax increases the cost of smoking and makes consumers pay a price closer to the social costs. From an economic perspective, it is more efficient if the price of smoking reflects its true social cost. (This is also known as the polluter pays principle). Also, the money raised can be used to reduce congestion and treat diseases related to smoking.
A tax on cigarettes also tends to increase revenue significantly. If you are addicted to smoking and the price increases, how much will your demand fall? Probably not very much. Evidence suggests if the price of tobacco increases 10%, demand falls 1%. Therefore, increasing tax on cigarettes leads to big increase in tax revenue for government. It is an easy way to increase tax revenues.
Q. Should we be concerned about a rise in the price of oil?
Rising oil prices tend to reduce living standards. It is an important cost for consumers and business. If oil prices increase, we all face increased costs of transportation. Because petrol is a necessity, we keep buying and so we see a fall in disposable income.
Also, rising oil prices tends to cause cost-‐push inflation and lower economic growth. This is an unwelcome combination of factors.
However, as oil prices increase, it does change some incentives which can help in the long term.
• It encourages consumers to consider other forms of transport less dependent on oil.
• It encourages firms to develop more efficient engines or develop forms of transport which use other fuel sources.
• Higher oil prices make the price closer to social cost.
Oil is a finite commodity. At some time, we will run out of oil, therefore an increase in the price of oil is an inevitability. Rising prices is the market response to the scarcity of oil. Higher prices do change behaviour and could help drive the development of energy sources which create less pollution. It would be a mistake to try and artificially keep the price of oil low.
Q. Why do firms spend so much on advertising?
Coca Cola spends several billion pounds a year reminding us that Coca Cola is a nice drink. This saturation advertising doesn’t increase the quality of the good, it just makes us very familiar with the brand name, and because of the cost of advertising we end up paying extra.
Because we feel Coca-‐Cola is the best, we become willing to pay a higher price. We could buy Tesco Cola for a lower price, but we don’t see it as a good substitute.
Through persistent marketing, Coca-‐Cola have made demand price inelastic. This means if the price increases, we are still willing to buy. Therefore, they can set higher prices and make more money.
It also creates a barrier to entry. A new firm may be discouraged from entering the cola market because it can’t hope to compete with the advertising budget of Pepsi and Coca-‐Cola. In a way it is very inefficient. Advertising leads to higher prices, discourages competition and helps Coca-‐Cola make higher profits. We could just buy Tesco cola, but we know it isn’t the real thing.
Q. Why are most brands of washing powder made by just two companies?
Unilever and Proctor & Gamble dominate the soap powder market. But, they each have multiple brands. If there were just two brands of soap powder, it would be easier for a new firm to enter the market. (If successful, they could get
33% of market share.) But, with 30 plus advertised brands, it is much more difficult. If successful, you may only get 3% of market share. The irony is that when they claim Persil washes ‘whiter than all the rest’. The rest are actually made by the same company!
Q. Why is Price of Coca-‐Cola in Supermarket much more expensive than a Vending Machine?
In a supermarket, you can buy a 1.5 litre bottle for £1.15.
In a theme park or vending machine, you could pay £2.00 for a smaller bottle 0.5 litre bottle.
The main reason is that in a supermarket you do have alternatives. In a vending machine or theme park, coca-‐cola will probably have a monopoly (the only choice of soft drink). Therefore, when there is no competition they can set a higher price. The theme park has a captive market; you aren’t going to spend 30 minutes going back outside to get a cheaper drink. Often for cinemas and theme parks it is selling food and drink that is the most profitable part of the enterprise.
Q. Why is Monopoly Considered Bad?
When a firm has monopoly power it has the ability to set higher prices. If your tap water company increase price, you are captive to them. You need tap water and you have no choice, (apart from buying bottled water which isn’t practical) The general idea is that competition prevents firms from charging high prices. A monopoly enables them to set higher prices.
It is also argued that if a firm faces no competition, it has less incentive to be efficient and provide a good service. Even if it is not attractive, you buy it because there is no alternative. An oft-‐repeated example is the old British Rail sandwich. On a train British Rail had a pure monopoly for selling sandwiches. You either paid £6 for a soggy bacon sarnie or waited until you got to your destination. In a city centre, British Rail sandwich shop would soon go out of business trying to sell the same sandwich for £6.
Q. Is Tesco Good or Bad?
Tesco has a degree of monopoly power. It has approximately 33% of market share for UK groceries. In some areas, Tesco has an even bigger regional market share. Tesco will argue they have many benefits:
• Lower prices. Because of their size they can benefit from economies of scale (basically big firms become more efficient). This leads to lower prices.
• Popularity. Their growth shows that people like shopping at Tesco’s because you can buy most things you want at a cheap price.
• They still face competition from other big supermarkets keeping prices low.
However, critics of Tesco argue:
• Their success has made life difficult for small retailers who can’t compete with the same levels of efficiency and economies of scale. This means that we have less diversity on the high street.
• Farmers complain supermarkets like Tesco can use their monopsony buying power to pay them lower prices. Because Tesco buys so much milk, farmers need to sell it to Tesco. Therefore, if Tesco is willing to only pay a low price, farmers have little choice but to make low profit.
• Tesco have taken business from specialist shops – e.g. selling flowers at discount. This has led to less diversity on the high street.
It is worth bearing in mind that Tesco is now one of the UK’s biggest employers. It’s success is due because people like shopping there. There is still room for specialist, independent stores. However, the dominance of Supermarkets has led to a decline in the independent stores, which some people feel is very important for the character and diversity of local areas.
Are Monopolies Always Bad?
Monopolies can have benefits for society:
• Patents. A patent is a good example of a pure monopoly. A legal patent gives a firm an incentive to spend money on research and development to develop new drugs. The reward of monopoly power thus creates incentives to take risks and invest in better products and develop life saving drugs. However, you could argue that drug companies then exploit this monopoly power and prevent access to life saving drugs.
• Monopolies can be efficient. Firms may gain monopoly power because they are efficient and successful. One view is that monopolies have little incentives to be efficient. But, on the other hand, a firm may gain monopoly power because it is efficient. Google created monopoly power through being innovative and successful.
Key Terms in Economics
These are some key terms in economics. It is not comprehensive but includes some of the more common terms.
• GDP (Gross Domestic Product) is a measure of national output (the size of the economy).
• Real GDP – In economics ‘real’ means we take into account inflation (prices going up). For example, if your income doubled from £100 to £200 you may think you’re better off. But, if the price of all goods doubled, then your ‘real income’ is still the same. Real GDP measures the actual increase in quantity of goods and services.
• Economic growth – This is an increase in national output. The rate of economic growth measures the annual percentage increase in the size of the economy.
• Recession – A fall in national output. Negative economic growth (The economy reduces in size)
• Inflation – This is the increase in the average price of goods in an economy.
• Inflation Rate – This is the annual percentage increase in prices. Inflation of 3% means that average prices are rising by 3% in a year.
• CPI Consumer Price Index. This is the headline rate for measuring inflation.
• Deflation – A fall in prices. • Unemployment – the number of people without work. • Balance of Payments – A record of financial flows between the UK and
the rest of the world. Note: this is not to do with the government but just all the money coming in and going out of the UK.
• Current Account on the Balance of Payments. This is part of the Balance of payments, which measures exports and imports of goods and services, investment incomes, and net transfers. E.g. a deficit on the current account means we import more goods than we export.
• Trade Deficit. This refers just to the imports and exports of goods. (Though when people talk of a trade deficit they often mean a current account deficit)
• Interest Rates. The cost of borrowing money and also the amount you may get from saving money in a bank.
• Bank of England. The Bank of England is the Central Bank of the UK. They have responsibility for setting interest rates, targeting inflation and other elements of financial regulation.
• Government borrowing. The amount the government have to borrow from the private sector to meet their shortfall.
• Monetary Policy. Using interest rates and other monetary tools (e.g. Quantitative easing) to control inflation and economic growth. Usually controlled by the Central Bank e.g. ECB and the Bank of England.
• Quantitative Easing. A policy by the Central Bank to ‘create money’ and buy government bonds. The aim is to increase the money supply and reduce interest rates. (Sometimes referred to as printing money)
• Fiscal Policy. The use of government spending and tax to influence demand in the economy.
• Saving Ratio. The % of income that is saved rather than spent.
Exchange Rates
• Exchange Rate. The value of one currency against another. E.g. $ to £ rate. • Appreciation in Exchange Rate. When one currency becomes worth
more against another. • Devaluation / Depreciation in Exchange Rate. When a currency
reduces in value. • Sterling Crisis. When there is a fall in confidence in the Pound Sterling,
causing the value to fall sharply. • Trade Weighted Index. This is a measure of one currency e.g. Pound
against many different currencies. It is weighted to give more importance to big currencies like the Euro and Dollar. It gives an overall picture of how a currency is doing.
• Monetary Union. When countries share the same currency and monetary policy, e.g. the Euro.
Financial Terms
• Government Bond – A type of loan by the government. • Bond Market. A government borrows money by selling ‘bonds’. These
bonds can be bought and sold on the bond market. Demand and supply in the bond market will determine the rate of interest that bonds pay.
• Stock Market. A place to buy and sell shares in public companies. E.g. a big multinational like BT offers shares as a way to raise money.
• Money Markets. A place where banks and investment trusts borrow money. Banks themselves often need to borrow money to meet a shortfall in liquidity.
• Short Dated Gilt. – Gilt is a type of bond. It is a way that the government borrows money. Gilts tend to be short-‐term borrowing. E.g. a three month dated gilt means the government promise to pay you back at the end of three months.
• Long Dated Bonds – With some bonds the government doesn’t have to pay you back for 20 or 30 years.
• Credit Crunch. A situation where it is difficult to borrow money because major banks are short of liquidity (money).
• Liquidity Crisis. Banks or governments can’t raise enough money to meet their short-‐term requirements.
• Lender of Last Resort. If a commercial bank runs out of money, it can go to the Bank of England who will lend it money when no one else will.
Housing Market
• Affordability. The ratio of house prices to disposable incomes. In the post war period house prices have increased faster than incomes making it more difficult for first time buyers.
• Capital gains This occurs when people have an increase in the value of their assets such as your house. This leads to the “wealth effect”
• Equity Withdrawal If house prices increase, owners can take advantage of this by re-‐mortgaging their house giving people extra disposable income. For example if you bought a house for £100,000 you could have a mortgage for that amount. If the value of the house increased to £130,000 the bank may be willing to lend you an extra £30,000
• Fixed Rate Mortgage. A mortgage where interest payments are fixed for a certain time period, e.g. 2 or 5 years.
• Interest Only Mortgages A mortgage where you only pay interest on the mortgage loan. You make no payment to reducing the outstanding mortgage debt.
• Mortgage repayments: To buy a house, people have to borrow money. Therefore they take out a mortgage, this loan is then paid back in monthly mortgage repayments
• Negative Equity. This occurs when there is a fall in the real value of the house. It means that if somebody wanted to sell their house they would get less for it in real terms than the original buying price.
• Stamp duty This is a tax that is paid on buying a new house. The more expensive it is, the more tax that is paid.
• Wealth Effect The most common form of peoples’ wealth is their house. If house prices increase, people feel wealthier and therefore spend more causing an increase overall demand in the economy.
Notes:
Data on interest rates published with permission of Bank of England. See Bank of England Revisions Policy (http://www.bankofenqland.co.uk/mfsd/iadb/notesiadb/Revisions.htm).
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