Will a falling Stock Market adversely effect the US and UK Housing Market?

With Global Stock Markets suffering their biggest fall for a decade, it is worth considering the economic effect of a fall in stock markets.

First of all it depends on the severity and length of the stock market fall. For example the stock market crash of 25% in 1987 didn’t cause any significant economic problems in the UK or US. Share prices soon recovered and in the UK the late 1980s saw a remarkable period of high economic growth. This was partly because; in response to falling shares, the UK govt cut interest rates and taxes to boost demand. There then followed a rise in economic growth and a rise in house prices.

However other experiences show us that falling share prices can have an adverse effect on the economy. Most notably the great depression was caused by the wall street crash of 1929. What happened in 1929 was that the fall in share prices was so big and prolonged that it caused a general decline in economic confidence and collapse of certain financial institutions. (especially medium sized banks in America) with a fall in confidence, firms reduced investment and consumers reduced incomes. This caused the initial fall in economic growth and rise in unemployment. These effects were magnified by an adverse multiplier effect. As people were made redundant they in turn spent less, causing further falls in AD and economic growth.

Furthermore a fall in share prices causes a fall in consumer wealth. There is a link between wealth and consumer spending. For example rising house prices often increases consumer spending because people can remortgage their houses. However generally wealth held in the form of shares is not directly linked to consumer spending. This is because most people who own shares do not base their consumption on the value of shares. Shares are seen as speculative investment. So even with wild fluctuations in the price it may have little impact on overall consumer spending. (It is also worth noting only a small % of the population have significant savings in shares).

Therefore a fall in share prices won’t necessarily affect the UK housing markets in an adverse way. Consumer spending and growth need not be derailed by a 5% fall in the Dow Jones. However a fall in share prices may make a contribution to a further decline in economic confidence. In America the US housing market is already in decline, with house prices falling. There is also persistent concern about the size of the US current account deficit and levels of debt. Therefore a falling stock market may further undermine economic confidence and make the prospect of a recession in US even more likely.

Labels: Stock Market, UK housing Market, US housing Market

Why does MPC and UK government worry about inflation? What are the reasons for having an inflation target of CPI 2% ?

Economics Costs of Inflation

1. Menu costs.

This is the cost of changing price lists e.t.c. However with modern technology this is less significant these days. E.g. Computerised bar codes make it easier to update.

2. Inflation creates uncertainty and confusion.

When inflation is high it also tends to be more volatile. It becomes more difficult for firms to predict future prices and costs, therefore they tend to reduce or delay investment decisions. Therefore this tends to adversely effect economic growth in the long term.

3. Lower Competitiveness

High inflation in the UK makes the UK less competitive compared to other countries. This will reduce demand for UK goods, causing lower growth and possibly balance of payments problems. This is increasingly important with the globalisation of the world economy. If we do lose competitiveness in the long term it is likely to lead to devaluation of the UK exchange rate.

4. Inflationary growth is unsustainable.

In the 1980s the UK experienced economic growth above the long run trend rate, however this also caused inflation leading to a boom and bust economic cycle. Keeping inflation close to the government’s target of 2% is one of the best ways of avoiding inflationary growth and maintaining sustainable economic growth like the UK has experienced since 1992.

5. Inflation reduces the value of savings.

This is because inflation erodes the value of money. This is likely to effect pensioners the most. Therefore inflation is thought to cause a redistribution of income within society from savers to borrowers. However this is only a problem if inflation is higher than the rate of interest. If interest rates are above the value of inflation then savers can still maintain the value of their savings. (so long as they don’t keep it in cash under their bed). This is not really a significant problem in the UK. Real interest rates usually remain positive.

6. Shoe leather costs.

This is the cost of looking around for the best deal. When inflation is high it becomes more difficult to know best deals. However this is only really a problem for very high levels of inflation.

Labels: inflation

How Effective have the MPC been in meeting the Governments inflation target?

The MPC are responsible for setting interest rates and determining UK monetary policy. They seek to keep inflation close to the government’s target of CPI 2% +/-1 %

Currently (Feb 2007) inflation in 2.7%

Advantages of MPC in setting interest rates.

1. They are independent. They are not subject to political pressures. E.g. they are not tempted to keep interest rates low before an election. This used to be a problem for UK economy, with many experiences of boom and bust economic cycles.

2. Monetary Policy is pre-emptive. They try to prevent inflation before it occurs. They predict future inflation trends. If inflation looks to be increasing above the govts target then they can increase interest rates to reduce consumer spending and keep inflation on track.

3. MPC have reduced inflation expectations. People have confidence that inflation will remain low. Therefore wage demands are lower and it becomes easier to keep inflation low.

4. By targeting inflation directly they get the best overall picture of the economy rather than focusing on small aspects like the money supply.

5. Since 1997 UK inflation has remained close to the government’s target of 2%. This is much lower than UK inflation in the 1980s which reached 10%

6. Interests rates have a powerful effect in influencing UK consumer spending. This is because many people have mortgages or other types of loans.


Limitations of the MPC’s Effectiveness

1. Inflation is low but this is partly due to global pressures keeping inflation low. E.g. globalisation, low prices of raw materials and better technology. If these factors were to increase it would be much more difficult for the MPC to keep inflation low.

2. Interest rates have a time lag. It is estimated it takes 18 months for interest rates to have an effect. Therefore it becomes difficult to control inflation solely through interest rates.

3. Some sections of the economy do not respond to higher interest rates. For example the recent rises in interest rates have not stopped house prices rising. Many older people have a small mortgage therefore changes in interest rates have little effect. However interest rates have a disproportionate effect on people who have just joined the housing market ladder.

4. It depends upon other components of AD. E.g. if consumer confidence is high then raising interest rates may have little effect on reducing consumer spending.

MPC have done a good job so far. However the real test may come when there is a rise in structural inflation or global instability.

Labels: UK economy, UK Monetary Policy

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 govt should set an example by reducing its debt. This example actually inspired members of the public to send in their savings in the hope that it would help the economy.

Alas this is precisely the worst response the Government could have taken. By reducing benefits they further reduced consumer spending and AD. This made areas of high unemployment even more impoverished. When people saved rather than spent their money it just made the recession worse. It was J.M. Keynes who was one of the most enthusiastic proponents of increasing government spending, even if it meant increasing the levels of borrowing. If the govt borrowed they could kick start the economy and hopefully generate a multiplier effect which would enable the economy to start growing.

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

This phenomenon explains why Keynes talked about the “paradox of thrift”. Saving money reduces spending, output and therefore increases the level of unemployment in an economy.

Labels: Keynes, theories explained

After several years of rapid growth in US House Prices. The US housing market has taken a sharp reverse in fortunes. The number of new houses being built has fallen considerably and in many states of the US house prices are now falling. There are concerns that this fall in house prices will leave the US consumers with negative equity and therefore could cause a fall in Consumer spending. In recent years it has been consumer spending that has been the main determinant of US economic growth. It has also played a key role in global economic growth. However although falling house prices will cause a significant reduction in US consumer spending the effects on the global economy are less than they may have been a decade or so ago. Emerging markets like India and China are seeing a developing middle class with an apetite for luxury goods. Thus if the US was to go into recession it need not cause the world to follow. It is also worth remembering the Japanese economy is starting to recover, the main driving force there is, at the moment, consumer spending.

Labels: Housing Market, US economy

1. Raises Revenue for the Government. If the governments gets more tax revenue it can mean either:

• a. other taxes can fall,
• b. the government can spend more on public transport
• c. or the budget deficit can reduce.

Nobody likes new taxes, but whether money is collected from new or old taxes makes no difference to the disposable income of the tax payer.

2. Increase social efficiency. In a free market the consumption of cars are overconsumed. When driving people ignore the negative externalities of congestion and pollution. The social cost is much greater than the private cost. Therefore it makes sense for the government to charge a much higher price of driving in congested areas.

3. Congestion is Inefficient Congestion costs the UK economy over £20 billion a year in lost output and wasted time. This should be tackled.

4. Reduce pollution and global warming. Pollution from cars is a significant contributor to CO2 emissions in the UK. Road charging should encourage people to look for other forms of transport which don’t pollute as much.

5. Save Journey Time - If you earn £15 an hour, why would you not like the idea of paying £7 to get home an hour earlier? Who enjoys sitting in a traffic jam?


Arguments against Road Pricing that are no good.

1. It is an intrusion on liberty. To drive you need countless documents. When you use electricity the electric companies measure exactly how much electricity you use. When you make a telephone call the telecom company know exactly whom you ring and charge accordingly. Why should driving be any different.

2. Govt is just using it to raise money. Is that not a purpose of income tax, VAT and every other type of tax? Raising money from a new tax enables other taxes to be lowered or spending to be increased.

3. Economic output is more important than Global warming. We shouldn’t worry about the future, the most important thing is keeping taxes low for the current motorist. Read the Stern Report.

4. Increases Inequality. This is true to an extent. A road pricing charge is a higher % of tax for those on low incomes. But so is the cost of buying a car and petrol. If concern about equality of distribution is an issue the govt can alter other taxes and benefits. A tax which increases efficiency need not be stopped on equality grounds. It is always possible to compensate the effects to others.

See also:

• Economics of Negative Externalities
• Diagram of Tax on Negative Externality
• Congestion
• Electronic Road Pricing in Singapore
• Road Pricing For and Against
  

Labels: economics, Road pricing, transport

Since the Bank of England was given independence in 1997 UK inflation has been close to the government’s target of 2% +/-1. This is a remarkable improvement for the UK economy. Previously the UK economy suffered from consistently high inflation. Eg in 1979 inflation reached 25%. In 1992 inflation reached 11%. Reasons for low inflation are a matter of debate. The chancellor Gordon Brown likes to take credit for giving the Bank of England independence in 1992. However although this partly explains low inflation, it is only a small % of the reason.

Reasons for Low Inflation in the UK

1. Economic growth has been more stable and predictable. The MPC have avoided a boom and Bust economic cycle. At the first sign of inflationary pressures increasing they have increased interest rates to reduce inflation before it occurs (policy is known as pre emptive monetary policy.) This has avoided a repeat of the late 80s inflationary boom.

2. Inflation expectations are lower. Partly as a result of the MPC’s greater credibility. People expect inflation to be low, therefore wage demands have been correspondingly lower. This has made it easier to keep inflation low.

3. The process of globalisation has helped to reduce costs and increase competitiveness in global markets. The UK has benefited from falling prices of manufactured goods that have been made in countries like China and Korea.

4. Improvements in technology. The internet and micro chip computers have helped to increase efficiency and lower costs.

5. Increase in the labour supply. Increased immigration has created a new supply of cheap labour which has helped keep wage pressures low.

6. Appreciation of £. This has helped reduce inflation, because imports are cheaper and quantity of exports lower

However inflation may increase in the future. The Governor of the Bank of England recently said there is no reason why the past period of stability and low real interest rates will continue. Several reasons may cause inflation to rise in the future including:

Why Inflation May Rise

1. Economic growth in China and India is causing high demand for commodities and therefore prices are rising. This will feed through into cost push inflation.

2. The UK has a large current account deficit. To reduce this deficit it will be necessary to have a devaluation in the value of £, at some point.

3. The supply of labour is unlikely to increase by too much in the future. Therefore wage inflation may become a problem as the labour market nears full employment.

4. UK House prices continue to rise. This creates additional consumer wealth and therefore increases consumer spending.

The effect of this is that in the future interest rates may have to rise in order to keep inflation low. This will have the effect of keeping mortgage payments high.

Labels: inflation, UK economy

Hi and welcome to a blog about Economics and in particular UK economics.

This blog is updated by Tejvan R. Pettinger. Tejvan studied Politics, Philosophy and Economics at LMH, Oxford University. He now works as an Economics teacher in Oxford. He also works as a senior examiner for Edexcel.

Contact Tejvan

Labels: UK economy