The US is currently running a budget deficit of $650 bn. Such a deficit seems hard to comprehend; it is greater than the combined GDP of several sub Saharan African economies.

1. It is important not to get confused with the current account (balance of payments) deficit. The current account deals with a deficit in terms of trade. Spending being greater than taxation causes a government deficit.

2. It is important to look at the deficit in terms of a % of GDP. For example the US budget deficit represents 3% of GDP. The national debt (total cumulative debt equals 63%) This is a lot but less than countries like Greece where national debt = 107% of GDP.

3. Most of the US national debt is not owned by foreigners but domestic finance bodies.

Problems of Budget deficits.

1. Increase national debt and annual debt interest payments. These represent taxation revenues spent on servicing debt. There is an opportunity cost; for example these debt interest payments could have been used on financing health care.

2. May require higher taxes and/or lower spending in the future.

3. Put upward pressure on interest rates. A large deficit means the government needs to borrow more. As this debt grows they may need to raise interest rates in order to encourage enough people to buy the debt. Higher interest rates cause lower growth and may crowd out private sector investment. This is known as financial crowding out.

Labels: budget deficit

When Mrs Thatcher came to power in 1979, the economy was generally considered to be facing severe structural problems including:

* Inflation of 27%
* Powerful Trades unions causing wage inflation and time lost to strikes.
* Unemployment increasing to a post war record of 700,000
* High levels of government debt that required politically sensitive borrowing from the IMF.

On coming to power in 1979, Mrs Thatcher lost no time in seeking to make a clean break with the past. Mrs Thatcher was heavily influenced by the idea of Monetarism and free market economics. In addition, she wished to “destroy” the power of the “Socialist / Communist” trades unions. On coming to power, the first policies of the Conservative administration were to tackle both inflation and the budget deficit.

The belief of Monetarism was that to control inflation you needed to control the money supply. To control the money supply, it was necessary to reduce any government deficit. Therefore, extreme deflationary policies were implemented. Firstly taxes were raised and government spending cut. Interest rates were also increased, as the government sought to reduce inflation. These deflationary fiscal and monetary policies did have the effect of reducing inflation; however it was at a cost of falling Aggregate Demand and lower economic growth. In the middle of 1980 the economy had been plunged into full scale recession, but the government still pursued its deflationary policies. As unemployment reached the unprecedented level of 3 million (1) There was widespread criticism of the government. During 1981, in a famous letter to the Times, 365 economists signed a letter calling on the government to alter its economic policy and put an end to the recession. (3)

With criticism mounting, even from her own party, Mrs Thatcher was under pressure to change course (a little like Edward Heath had in the early 1970s) However, in a now famous speech at the 1980 Conservative party conference, Mrs Thatcher stood up and defiantly said.


”You turn if you want to, but this lady is not for turning.”(2) It encapsulated her stubbornness and resolve. Fiscal policy and monetary policy remained tight, and unemployment remained close to 3 million until 1986.

The deflationary fiscal and monetary policy’s were exacerbated by 2 factors.

Firstly in the early 1980s sterling became an important petro currency; with the production of oil in the north sea. The £ rose rapidly. Combined with rising interest rates, sterling appreciated from £1 to $1.5 to $2.5. This appreciation in the pound adversely affected Britain’s exports and manufacturing sector. It was here, that the UK suffered the worst effects of the 1981 recession.

Secondly, controlling the money supply proved to be much more difficult than theory predicted. Despite rising interest rates and falling AD, growth in the money supply remained stubbornly high. This encouraged the government to maintain a tight fiscal and monetary policy. Inflation fell but the money supply didn’t; the link between money supply and inflation proved to be very tenuous, but by trying to reduce the money supply they reduced AD by more than was necessary.

On the one hand, inflation was reduced, but arguably it could have been done with much less pain. In seeking to meet spurious money supply targets they caused an unprecedented level of unemployment. This unemployment caused not only personal loss but widespread social problems. The mass unemployment, associated with inner cities, was very closely responsible for the riots which sparked across Britain in 1981.

Public anger at the Conservative economic record was to a large extent mollified by the patriotic success of the Falklands War. Riding on the back of a successful military victory, and a Labour party hopelessly divided, Mrs Thatcher was returned to power in 1983; ready for her next challenge - to take on the miners.

References

(1) Highest since Great Depression

(2) BBC 1980 - Mrs Thatcher
(3) Economist letter to Times

• Thatcherite Economics
• Economics, Mrs Thatcher and the British voter at Amazon.com
• Recession of 1991-92
• Causes of Recessions - Economic Theory
  

Labels: Mrs Thatcher, UK economy

After oil the most frequently traded commodity in the world is coffee. Coffee is an important export for many developing countries and coffee bars have become increasingly popular as an alternative to the old fashioned pub. Coffee is big business.

The price of coffee can vary hugely. I am currently writing this essay at Café Nero in Blackwells Bookshop Oxford. For a small cappuccino it cost me £1.95. On the one hand this is expensive; especially if you consider the raw materials of coffee and milk cost less than 4p. How do Costa Coffee justify charging such a high profit margin?

1. We are not just paying for the coffee but for the opportunity of sitting in a pleasant environment for up to 1 and half hours. Not only can I spend as long as I want but I can also consult books to help me write essays. (1) From this perspective £2 to stay in a premium location in the centre of town for 1 hours seems quite a good deal.

2. Coffee shops have to deal with low volume. A pint of beer in a pub used to have a low profit margin, but customers would regularly drink several pints. Lower profit margins worked because they were able to sell quantity. Coffee is not the kind of drink where you consume more than 1 or 2. With lower volume coffee shops need a higher profit margin to maintain profitability.

3. Price Discrimination. Like any firm coffee shops are seeking to charge the profit maximising price. Many consumers have a very inelastic demand for coffee. This is because there are few close alternatives to coffee and it is a relatively small % of income. If the coffee had been £3.00 I probably would still have paid it. The challenge for coffee shops is to find a way to charge to more to people like me without putting off customers who are sensitive to price changes.

4. Charging for Extras. This idea of price discrimination can be viewed in more detail by looking at how coffee shops charge for extras. One example is the extra price charged for the “fair trade” version. Fair trade coffee involves paying poor farmers a premium for their coffee. This can help them to gain a decent living. Café direct pay a premium to farmers of about 45p per pound. However to make a cappuccino requires only ¼ an ounce of coffee. Therefore the extra cost should be equal to less than 1p. However most coffee shops charge a premium of at least 10p. (1) This means most of the extra price goes in higher profit to the coffee shops.

However there are many customers who are price insensitive therefore they do not mind paying an extra 10p. In effect they are paying a premium for enjoying coffee with a conscience. From the firms point of view they are grasping consumer surplus from those with inelastic demand.

Other extras on offer at Costa coffee.
5 oz Soya milk (instead of milk) 30p
Decaffeinated 30p
Syrup 40p





(1) Tim Harford The Undercover Economist p33.

Labels: coffee, economics explained

As oil starts to run out the price inevitably increases. Demand for oil is inelastic (higher prices only have a small impact on reducing demand) therefore as supply falls there is a correspondingly bigger increase in price. Basically this is good news for oil producers and bad news for oil importers.

Problems of rising Oil Prices in the west.

1. Increased economic dependence on Oil producing countries. With each increase in the price of oil it gives increased economic and political power of Oil producing countries, which happen to be mostly in the middle east.

2. Inflation. Increased price of oil leads to higher costs for transport. This has the effect of increasing the price of most goods produced in the economy. Therefore it can contribute to rising inflation. This rising cost-push inflation makes it more difficult for the MPC to keep inflation within the government’s inflation target of 2% without lowering growth rates. In the 1970s a tripling of the price of oil contributed to stagflation, a corresponding mid of rising prices, falling growth and rising unemployment.

3. Balance of Payments deficit. A rise in the price of oil automatically makes the value of imports more expensive. Therefore oil-importing countries will experience deterioration in the current account. In the long term this may reduce the quantity of other imports they can afford. It can also lead to devaluation in the exchange rate reducing the value of the Domestic currency.

4. Market failure in developing alternatives. In theory economic principles suggest that as oil becomes scarce it becomes increasingly attractive to develop alternatives. Already cars can run on alternative energies such as Gas and hydrogen. As oil runs out firms should invest more in these alternatives creating an economic alternative to oil. However there is no guarantee that the free market will develop alternatives to offer the same benefits as oil.

Benefits of Rising Oil Prices.

1. Will have the effect of limiting growth in demand for oil and petrol. This will help to limit CO2 emissions, a major contributor to global warming.

2. Encourage greater efficiency of engines. The US in particular has a wide range of inefficient cars SUVs that contribute the most to global warming. Higher oil prices will reduce demand for these.

Revision notes on Oil at tutor 2u

Labels: economics explained, oil

With an unexpected strong rise in consumer spending in February and January interest rates are likely to increase in the near future.

House prices also continue to rise also adding to inflationary pressure.

The MPC increase interest rates to reduce inflationary pressures in the economy. They seek to keep inflation within the governments target of 2% +/- 1. Inflation is currently 2.7% but rising consumer spending could increase the inflation rate.

The effects of rising interest rates in the economy are quite varied but mainly involve reducing the growth in consumer spending and hence reduce economic growth.

View: Effects of increasing interest rates in the economy

Labels: interest rates, UK Monetary Policy

Economic Benefits of EU for UK

1. Free Trade with EU trading partners. Trade with EU countries now accounts for over 60% of UK’s trade (compared to 16% for US). This has helped create jobs in the export sector and is an important determinant of UK growth.
2. Lower Prices for Consumers. Free trade and increased competitiveness of the EU has enabled consumers to benefit from lower prices, at least for some goods.
3. Regional aid. Areas like S. Wales and the North East of England benefited from European regional grants which helped the local economy’s improve. However the UK no longer has any relatively deprived areas (after eastern countries entered)
4. Harmonisation of Rules and regulations: These have reduced costs for business.
5. EU rebate (negotiated by Mrs Thatcher) means that membership of the EU costs effectively very little.

Economics Costs of European Union for the UK.

1. Common Agricultural Policy has inflated prices of agricultural goods.
2. Common Agricultural Policy has been a major stumbling block in trade negotiations making it more difficult to reduce tariffs on UK exports. Thus some UK exporters have lost out as a result of EU’s protectionism in agriculture.
3. Common Agricultural Policy has tended to favour large farmers. Thus it has done nothing to reduce inequality within agriculture. The CAP has also tended to perpetuate inefficient farms. Although reforms to CAP have reduced the quantity of food surpluses there is still a significant % of the EU budget spent on subsidising inefficient farms.
4. Cost of bureaucracy and European parliament. Although the press have often exaggerated the real cost of the EU it remains an extra level of bureaucracy for the UK to deal with.
5. Free movement of labour has caused pressure on housing within the UK in certain cities like London. On the other hand immigrants from Eastern Europe have filled various job vacancies and played an important role in the economy.

See also: benefits EU

European Union

Labels: european union

I am currently teaching an A Level Easter Revision college at Jesus College. Our teaching room is right at the top with a great view of the Spires of Oxford.

The course is organised by Cherwell College, Oxford. It lasts for 3 weeks but I am just doing 1 week.

Labels: easter revision

A simple Monopoly Diagram.

Profit Maximisation will occur where Marginal Revenue MR = Marginal Cost MC.

The Green shaded area is the level of supernormal Profits (AR-AC) Q

More on Monopoly

This is a photo of a diagram I drew on a white board. Much easier using a digital camera than using word and lots of lines. It will make it much easier to add diagrams to Economics Help.

Soon I hope to put up my Economics Revision Guide. It is more professional than the current notes. I think it will be very helpful for students and it will be free! (not for resale of course)

I also have many model Economics essays which will go up at some time.

Monopoly Tutor 2U

Labels: economics explained, monopoly

I recently wrote an essay does Economic growth increase Happiness?

"Increasing rates of economic growth has long been the holy grail of conventional economics and politics. To a large extent most developed economies have been highly successful in increasing economic output. But has such an impressive increase in national output actually improved people's standard of living?"

Costs and limitations of Economic Growth include factors such as:

1. Pollution
2. Diesease of affluence
3. Higher Crime
4. Longer working hours and more stress
5. Diminishing marginal utility of extra income.
6. Increased Inequality

Are we better off because of growth. Will future economic growth solve our problems or just magnify our existing ones?

What do you think? Feel free to leave a comment.

Labels: economic growth

After 11 consecutive years of being Chancellor of the Exchequer Gordon Brown is the longest serving chancellor since 1820 overtaking David Lloyd George (2). As Gordon Brown wrly noted as chancellor Lloyd George successfully combined both being chancellor and being PM. In fact his last budget speech sounded in parts like a pre – election budget. – If not a general election at least a leadership election.

Quick Summary of the 2007 Budget

1. Income tax cut from 22p to 20p. This is largely financed by abolishing the 10p starting rate and removing allowances in N.I contributions. – “The tax man giveth and the tax man taketh away.”
2. Corporation tax cut from 30% to 28%. This will largely be financed by raising the tax rate on small business from 20% to 22%. The justification was that it was to avoid people using small companies as a way to reduce income tax burden. However it is strange to increase corporation tax to 22% when income tax falls to 20%. Tax relief on capital investment was also reduced from 25% to 20% this will particularly cost manufacturing firms.
3. Environmental taxes. Road tax on gas guzzlers will double. Tax on petrol will rise above the rate of inflation in the future. This will have quite a limited impact. Evidence suggests raising road tax does little to reduce the demand for SUVs which cost in the range of £20,000 - £30,000. Overall on the environment Gordon Brown can be accused of just tinkering at the edges. It will do little to make the target of cutting CO2 emissions by 70% a reality.
4. Increase in Child Benefit. The reduction in tax credits means many on low incomes have an effective marginal tax rate of 70% (with income tax, NI and reduction of benefits and tax credits)
5. Increase in Pension credits, but the means tested nature of this benefit discourages savings in the long term. E.g. when a single person pension passes £6,100 they have a 40% deduction in tax credit.
6. Economic Record. The economic performance of the UK continues to remain impressive with economic growth edging upto 3% and inflation still on target for 2%. However an interesting question is how much credit will the voters give to Gordon Brown? Polls suggest the Conservatives are ahead in both economic management and perspectives on the environment

To summarise the overall impact of the budget one could use this choice expression of David Smith, economist at the Times.

“This chancellor is like one of those people you shake hands with only to discover a couple of days later you are missing a couple of fingers.” (1)

Labels: Gordon Brown, UK Budget, UK economy

Markets were disappointed as the Consumer Price Index CPI measure of inflation rose from 2.7% to 2.8%.

The CPI measure is the government's preferred measure. However many feel it doesn't reflect their personal changes in the cost of living. The CPI excludes several items such as: council tax, mortgage costs or house price changes.

The old RPI measure increased to 4.6% driven higher by rising interest payments and council taxe rises.

Inflation Rates for Pensioners

It is estimated that for pensioners the true cost of living may be rising as high as 9.1%. This is because they spend a higher % of their money on things like Gas and council taxes. Pensioners are increasingly indebted as their costs of living rise faster than their incomes. (1) Pension and other benefits are calculated according to CPI inflation.

• Definition Inflation
• Costs of Inflation
• Measuring Inflation

Inflation rate reaches 4.6%

Labels: inflation, UK inflation

After criticising the EURO, at least arguing the UK should not join. I think it is only fair to remember some of the benefits of the European Union.

Not least amongst the achievements of the EU include:

1. Peace amongst nations - European Union countries are no longer at loggerheads like they were in the past.
2. Economic development of countries like Portugal, Ireland and Spain.
3. Free Movement of workers across Europe.
4. Prospect of membership has helped modernise Turkey.

There are 50 reasons here at the Independent: 50 Benefits of the European Union

I think the best of all 50 is this one:

50. Lists like this drive Eurosceptics mad

In the Daily Mail-Sun universe, the EU can never do any good. Brussels is an insane bureaucracy, which secretly plots to have all donkeys painted blue (with yellow stars). The 50th birthday of the European project is a time to celebrate the many positive things which the EU has brought us.

• European Union
• Benefits of Joining EURO

Labels: european union

To measure inflation the Office for National Statistics needs to find out the 1000 most common items bought in the UK. Each year they conduct a Family Expenditure Survey to find out what people spend their money on. - Measuring Inflation

• Problems of measuring inflation

Recent Items Added to CPI

• Broccoli
• Olive oil,
• Probiotic drinks, such as Yakult and Actimel,
• mobile phone ringtone downloads,
• credit card charges
• and mortgage arrangement fees.

Items Excluded from CPI

• Brie
• VHS recorders,
• video cassettes and
• bulky cathode-ray tube television

Generally food items have been downgraded, services have become more important

The March inflation figures are due out today and are forecast to be around 2.7%

Labels: inflation

Despite a recent improvement in EU growth (last year GDP growth was 2.9%) there are concerns over fundamental problems with the EU economy. In recent years by far the worst performers in the EU have been the big 3 of Germany, Italy and France. Germany for example has experienced 6 years of sluggish growth and poor productivity rates. The OECD estimates that productivity growth in the EU has averaged only 1.5%, which is lower than comparative rates in the US.

Reasons for the Slowdown In European growth

1. Some slowdown inevitable after wonder years of 1950s and 1960s. 50 years ago, as the Treaty of Rome was being signed, the German economy was undergoing a period of tremendous growth, combined with low inflation and low unemployment. To some extent a slowdown from this rapid expansion is a reflection of a maturing economy. However this is only a partial explanation.
   
   
2. German Reunification. This has often been used to explain low growth in Germany and hence EU. Reunification was very expensive causing high levels of government borrowing. Because of high borrowing levels interest rates were higher than they needed to be. This was certainly a constraint on German growth in the 1990s however 17 years after the fall of the Berlin wall this is becoming increasingly less significant.
   
   
3. The EURO. In particular it is argued that Germany joined the Euro at a rate that is too high making its exports less competitive. Other countries are also experiencing declining competitiveness as a result of a strong EURO. Italy has managed growth of only 1.3% since joining the EURO. Spain has a current account deficit of 8.5% of GDP; a reflection of poor competitiveness.
   
   
4. ECB is too concerned with low inflation The ECB has been accused of giving too much priority to the goal of low inflation. It is argued they have sought to maintain low inflation at the expense of lower growth. Note their target is less than 2% rather than 2% +/-1 as in UK
   
   
5. Growth and Stability Pact. This is a constraint on expansionary fiscal policy because in theory it limits governments borrowing to 3% of GDP. Therefore in a recession a government is unable to use monetary policy (ECB set rates for whole Euro zone) but also they are unable to reflate the economy through higher spending and borrowing. However in practise these rules have proved to be sufficiently flexible; there has been no attempt to penalise countries like France and Italy who have broken them.
   
   
6. Inflexible Labour Markets. This is frequently held up as a constraint on economic growth. In particular rigidities in the labour market discourage investment from abroad. For example in France there are laws which makes it difficult to fire workers once they are hired. This discourages firms from expanding and investing. Both the IMF and OECD have argued that further labour market liberalisation is needed to regain competitiveness. Even many of the European leaders acknowledge it is a necessity. However such reforms often face stiff opposition from powerful interest groups who wish to protect the interests of their members. Thus reform has proved very difficult and exceedingly slow. As Luxembourg’s Mr Juncker once said.
   ”We all know what to do, we just don’t know how to get re-elected after we’ve done it.”
   
   
7. Demographic Changes. Countries like Germany and Italy have a declining birth rate. This means that the population structure is becoming weighted towards those who are over 50. The traditional population pyramid is being inverted. The increased demands placed on benefits and decline in tax revenue is a serious burden for government spending. It is reflected in burgeoning public debt. As of 2006 Italy’s public debt stood at 105%. German and France just below 70% of GDP. Such high levels of debt are argued to cause crowding out of private sector spending. Unfortunately this problem is likely to be exacerbated as the 1960s baby boomers retire. Again there is much opposition to the reform of generous state pensions.

See also:

• Why UK will not join Euro
• Blog entries on Europe
• Costs of Joining Euro

References

• EU economic growth

Labels: EU economic growth, Euro

Since becoming Chancellor in 1997 Gordon Brown has presided over the longest period of economic expansion in the UK since records began. He is widely credited for having been a model of fiscal prudence which has allowed the UK to go from the laughing stock of Europe to one of the best performers in the OECD.

Is Gordon Brown Britain’s best chancellor ever? Or is it more a case of being lucky to inherit a promising economic situation? Or is it as some people suggest an opportunity wasted, storing up economic problems for the future?

This is a short economic evaluation of Gordon Browns’ record as Chancellor.

Achievements of Gordon Brown as Chancellor of Exchequer.

1. Independence of Bank of England.

4 days into his job he handed over control of Monetary policy from no.11 to the Bank of England Monetary Policy Committee. This is widely regarded as being a key factor in creating economic stability and a low inflationary environment for the long period of economic expansion. (Note the Conservatives had made moves towards independence, making the step easier to make)

2. Longest Period of Economic Expansion on record.

Economic Growth has averaged 2.8% between 1997 – 2006 also the growth has been remarkably stable, the boom and bust cycles which characterised the 80s and early 90s have been completely avoided. The success of high growth and low inflation has earned generous praise from the IMF and World Bank. The chief economist of OECD, Jean-Philippe Cotis, described Britain as a "goldilocks" economy – This means they had the perfect balance of strong growth and low inflation. "It is in fact surprising how stable the UK economy has been. It is doing very well." (i)

3. Unemployment has fallen to the lowest level since the early 1970s.

In May 1997 the number unemployed was 1.7 million, this has now fallen to 925,000. (However it is worth noting the ILO measure, which doesn’t rely on govt statistics shows a higher figure.)

4. Fiscal Prudence.

On coming to power Gordon Brown imposed a rule of fiscal prudence saying government borrowing should never exceed more than 3% of GDP over the course of the economic cycle. This justified some tough public spending decisions in the early years. However in recent times he has been close to breaking his own fiscal rule due to more extravagant spending on health and education.

5. Avoided potentially difficult economic situations.

Although certain global factors have helped the UK economic performance Gordon Brown would point to potentially destabilizing influences which could have made things worse. For example; the dot com Boom and bust; the housing boom which threatened inflation; and the mild recession in Europe our main trading partner. None of these knocked the economy of target.

6. Inflation on Target.

Inflation has remained within the government’s target of CPI 2% +/-1. This is a remarkable record considering the recent inflation history of the UK. True much of the credit can be given to other sources. But unlike the previous Conservative governments, Gordon Brown never allowed himself to get carried away into thinking there had been an economic miracle. The Conservatives belief the economy could grow at 4%+ in the 1980s caused the boom and bust of the 1991.

7. Avoided Joining the EURO as the Eurozone went into recession.

His 5 economic tests were designed to prevent premature entry. There seems little interest in reviving such as idea. The UK has not been burdened with an interest rate unsuitable for the UK economy.


See also:

• Criticisms of Gordon Brown's Economic Record as Chancellor

References


i) Gordon Brown's Record

Labels: Economic News, Gordon Brown, UK economy

Gordon Brown has been Chancelor since 1997, despite impressive growth figures some argue he was lucky to inherit a strong economic foundation and actually the last 10 years represented a wasted opportunity to secure the long term future of the UK economy

1. He inherited the benefits of Supply side reforms.

It is argued by the Conservatives that when he took power the economic fundamentals were already in place for a strong economy. Unemployment was already sharply falling from 3 million to 1.6 million. Over the past 20 years policies such as Privatisation and labour market reforms had helped increase the UK’s competitiveness and placed the framework for low inflationary growth. Gordon Brown was merely lucky to inherit these.

2. A Tax Meddler.

Gordon Brown has introduced over 66 new types of tax. Although he has kept his promise of not raising income tax he has compensated by introducing new types of taxes like Airport tax, such taxes have been labelled “stealth taxes”. Depsite tax rises the government is close to breaking its own public sector borrowing rules. Despite 12 years of economic growth government borrowing stands at £38bn or 3% of GDP.

3. Public Sector spending has been inefficient.

Gordon Brown has increased spending on public services like health and education however these have failed to deliver good results in terms of improved services. It has been argued that much of this spending has been on “non jobs” e.g. extra layers of management in health care. A report by Centre for Policy Studies argues that productivity in the public sector has fallen by 1.3% in 2003 + 2004. However Private sector productivity has increased. (Source 1) Thus the tax raises have been inefficiently spent and will result in lost growth in the future.

4. Complicated tax and Benefit system.

Making tax credits means tested has meant that most recipients are unaware of their eligibility. For example a significant proportion of child tax credit goes uncollected.

5. Unbalanced Growth.

The strong economic growth masks the unbalanced nature of the growth. The main contributor towards economic growth has been consumers spending. The increase in consumer spending has been financed by rising house prices and record levels of borrowing. The unbalanced nature of the UK’s growth is reflected in the record current account deficit of 2.9% of GDP (3)

6. Housing Bubble could bust.

With much of the economies strength being based on rising house prices, if a housing boom was to turn into a bust it could have a disastrous effect on the economy. It is worth noting the US housing market is experiencing problems of high levels of mortgage defaults and falling prices. This could also happen in the UK.

7. Unreformed Pensions.

The UK faces a demographic time bomb with the % of retired workers due to rise in the next 20 years. Industry experts have criticised his pension reforms as being too timid.

• See also: Success of Gordon Brown during his time as Chancellor

References


(1) Brown Blows it - Money Week

(2) Brown's Record

(3) Balance of Payments statistics

(4) Economic Problems of EU

Labels: Economic News, Gordon Brown, UK economy

As Gordon Brown approaches his last budget as chancellor many are reviewing his tenure as Chancellor and evaluating his success or failure. One important contribution he made was to steer the UK away from joining the Euro on the ground that "it would not be in Britain's economic interest". The justification for this was based on his 5 economics tests.

Before deciding whether the UK should join the Euro the Chancellor, Gordon Brown drew up 5 economic tests which the UK must pass for the UK to join. The main principle behind these 5 economic tests was whether the UK would cope with a common monetary policy. The 5 tests are in some ways superfluous. The main test being is really whether the UK has a degree of economic harmonisation with the rest of Europe.

5 Economic Tests for Joining the Euro

1. Economic Harmonisation.
   
   The UK economy must be harmonised with the Euro zone. If the UK economy was growing much faster than EU then UK interest rates would need to be higher. For example, at the moment if the UK joined interest rates would fall and this may cause inflation. Therefore it is essential that the UK has a similar economic cycle to Europe. Even if there is temporary harmonisation there is no guarantee it will continue on a permanent basis.
   
   
2. Is there sufficient Flexibility?
   
   If the UK went into recession could it be able to cope? It would have no influence over Monetary policy but also Fiscal policy is limited by the growth and stability pact. This limits the amount of government borrowing and therefore limits the scope for expansionary fiscal policy.
   
   
3. Effect on Investment.
   
   Would joining the euro create better conditions for firms making long-term decisions to invest in Britain? UK inward Investment has not suffered since the UK decided not to join
   
   
4. Effect on Financial services.
   
   What impact would entry into the euro have on the UK's financial services industry? London as a financial centre has boomed in recent years.
   
   
5. Effect on Growth and Jobs
   
   Would joining the euro promote higher growth, stability and a lasting increase in jobs? There is no clear evidence that it would. UK economy has done better outside the Euro than in the Euro.

At the moment the weight of economic opinion is that the UK is better off not joining the Euro. One important factor is that the UK housing market is very sensitive to interest rates. Many UK householders are homeowners and also many mortgages are variable. Therefore the cost of mortgages fluctuates with changes in the base rate. Thus a small change in European interest rates could potentially have a damaging effect on UK economy. For example, if the UK was to join now, interest rates would fall causing a potentially harmful inflationary boom.

See also:

• Why the UK will never join the Euro.
• Benefits of Joining Euro
• Costs of Joining Euro

Labels: Euro, Gordon Brown, UK economy

A look at factors that have contributed to the US current account deficit which has been over 6% of GDP for several years

1. US consumer spending has been rising rapidly due to a combination of
   
   • Tax cuts
   • Low interest rates
   • Rising house prices (although this is now being reversed)

Therefore with rising consumer spending the US has been increasing the value of imports bought into the economy. Furthermore the US has a high marginal propensity to import. Many luxury good like electrical goods and cars tend to be imported. It is these kinds of goods which are bought when incomes rise.

2. Decline in competitiveness. US manufactured goods have been losing comparative advantage to Asian economies. The primary reason is that wage costs in US are much higher than Asian economies. In particular China has seen its trade surplus with America grow due to its low labour costs.
   
   
3. Dollar Relatively High compared to current account deficit. Dollar has not devalued as much as you would expect for an economy with a large current account deficit. The US has remained an attractive location for Capital investment. In particular China has been buying a lot of US government securities. Therefore this inflow of capital has financed the current account deficit and encouraged America to keep buying imports. The inflow of capital has also enabled interest rates to remain low. Because China has bought so many US government bonds the US has been able to finance its national debt whilst keeping interest rates low. These low interest rates have encouraged consumer borrowing and consumer spending; a major cause of the current account deficit. In the past 12 months the dollar has been in decline but to reduce the current account deficit it would need to fall by more than 20%

Labels: current account, US economy

Economic Growth in India has increase to a record 9.2% Many economists see this as a sign India at last will be able to fulfill her potential to alleviate poverty and become a modern successful economy.

See: Reasons to be optimistic about state of the Indian Economy

However despite the high growth rates the Indian economy still faces many potential problems. In the short term inflation could become a significant problem as the economy gets close to full capacity. Unlike China the Indian economy has serious supply side constraints in certain areas like lack of investment. This means that the capacity to grow at 9% may be not possible to sustain in the long term.

See: Problems facing Indian Economy

Also see State of Indian Economy 2007

Indian Market Economic Overview

• GDP Growth 2001- 05 6.8%
• Current GDP growth 9.2%
• Inflation 2001-05 4.0%
• Current Inflation 6.2%

Indian Population 1.08bn Population growth 1.5%

Picture of Taj Mahal: Unmesh Swanson Sri Chinmoy Centre Galleries

Labels: Indian economy

If you are a student studying economics These 10 tips will help make Economics seem a little bit easier:

• Help for Studying Economics

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Due to China's huge current account surplus there stock of foreign currency reserves continues to mount. Jin Renqing a Chinese Minister recently announced plans to create a special agency to look into the best way to invest their $1,000 bn foreign currency reserves.

Upto now the Chinese have invested a significant % in United States Treasury bonds. This is seen as a low risk investment strategy. However for various reasons the Chinese are likely to diversify their investments. For example they could take holdings in companies around the world. In particular they are likely to invest in commodity producers. Chinese rapid growth is causing the demand and price of commodities to rise. In the long term this will give China greater political sway over other countries who benefit from their investment. Up to now the Chinese have taken an inward looking approach to world affairs. But this could change as they increasingly flex their economic muscles.

If the China loose their appetite for low interest bearing dollars it could mean that US interest rates will have to rise, to attract other investors. It will also make it difficult to finance the current account deficit. Therefore the dollar is likely to fall further.

However the Chinese own so many dollar assets they have a vested interest in preventing a significant fall in the dollar. With nearly $1 trillion to invest they are likely to continue buying bonds.

See also: Why US dollar likely to depreciate

source: China to open fund for investment at NY Times

Labels: Chinese economy, US economy

A current account deficit measures the balance of trade in

• goods
• services
• Net Investment incomes

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

The financial account comprises of 2 main features:

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

Some economists argue we need not worry about a Current Account Deficit. This is because:

1. If a current account deficit is financed from long term capital inflows then this can be beneficial for the economy. Inward investment can increase the productive capacity of the economy.

2. In an era of globalisation it is much easier to attract sufficient capital flows to finance the deficit.

3. If the deficit gets too large it will cause a devaluation which helps to reduce the deficit. Also when there is a slowdown in consumer spending the deficit will fall.


Reasons to Worry about a Current Account Deficit.

1. There could be problems financing the deficit in the long term. A short term deficit is not a problem, but if you have a deficit of over 6% of GDP then it is a problem if you rely on Capital flows. A significant part of the current account deficit in US is finance by Chinese investors buying US securities, at relatively low interest rates.

2. Most countries would not be able to borrow such large amounts at low interest rates. The US currently can because the US is seen as the World’s reserve currency. However if attitudes to the US economy change and investors lose their confidence in the US economy, they will stop buying US debt. This will cause 2 problems.

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

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

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

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

See also

• Is the US economy heading towards recession?
  
• Do Current Account deficits matter?
• Do Current Accound deficits matter? Axel Merk, May 23rd 2006

Labels: current account, economics explained, US economy

1. Immigration causes Unemployment.

It is an argument often repeated. It goes something like this. “Immigrants who come over here are willing to work for lower paid jobs and thus they create unemployment for local people.”

This argument is wrong because.

• Immigrants increase the supply of labour but they also increase Aggregate Demand in the Economy. This means that they buy more goods and create additional demand in the economy. They provide labour supply and increase labour demand.
• If immigration caused unemployment why did America not have high unemployment during times of mass immigration? Because the immigrants created as many jobs as they took.
• Often immigrants take jobs that native workers just don’t want to do. – You won’t see big multinationals cueing up to stop immigration.
• Furthermore immigrants tend to be of working age. Therefore they tend to contribute more tax than receive in benefits. Without immigration US demographics would have a larger % of dependent old people.

2. House Prices in London will keep rising because of shortage of supply.

True there is a shortage of supply in big cities like London and New York. However this doesn’t mean house prices will always keep on rising. House prices can fall just like anywhere else. It just means that they will be higher on average than elsewhere in the country. Note house prices in Tokyo and Japan fell over 25% after the end of the speculative bubble in the 1980s. – American house prices have a lot further to go.

3. War is good for the Economy.

This fallacy is deeply embedded in many people’s mind. One reason is because it was felt the Second World War ended mass unemployment in US and UK.

To some extent it is true unemployment fell because of the Second World War. However war is not necessary to solve unemployment. The government could have intervened to create jobs through public work schemes.

• War does create more output, but only in some industries related to war. Arms manufacturers do very well out of war. But total output of the economy doesn’t increase instead there is a change in economic priorities. Resources are diverted from peaceful industries to industries for creating the mechanisms of war.
• Increase in government spending for wars create either taxes and or higher debt payments. This is a burden on current and future taxpayers. Note The UK is still paying off debt from second world war.

4. Tax Cuts make people work harder.

• Ronald Reagan’s economic advisers told him something along the lines of “cut taxes” and you can increase total tax income. This theory is based on the laffer curve which states that if taxes are 100% people won’t work. Therefore if you cut taxes more people work and you can increase tax revenue.
  

• The problem is that this may work if you cut taxes from 95% to 90%. But when you cut income tax from 25% to 23% it doesn’t make any difference.
• Some people want a target income of say £20,000. Thus if taxes fall they can earn the same by working less. Empirical evidence suggests there is little if any supply side incentive for cutting US or UK tax rates.

5. A Current Account deficit doesn’t matter.

Maybe this fallacy isn’t so common. But it is a common belief in the Current US administration. A current account deficit of 7% of GDP does matter. See: Does a Current Account deficit Matter?

6. Trade Wars. - Retaliation is Best

• The instinctive reaction of politicians is that if one country places a tariff barrier on our exports, we should respond by doing the same. However economic theory suggests that placing a tariff barrier on imports leads to a loss of economic welfare. It is better to not retaliate.

7. Tax Cuts will boost the Economy.

• Another justification given for cutting income tax is that it will increase Aggregate Demand and hence increase economic growth. However this is not always true because:

• If you cut income tax for high-income earners, they are likely to save a high % of their extra disposable income. Their marginal propensity to consume is low.
• If you cut income tax the government has to either cut government spending or borrow. If the government has to borrow from the private sector then they will have less income to spend causing a decline in private sector spending.
  

• This is called crowding out. (Although there are certain times when a government deficit can boost AD – like in a recession.)

See also: Ten Economic Fallacies

Labels: economics, economics explained

Is the US economy set for further growth or is a recession an inevitability for an economy that has been living beyond its means for a long time?

With Alan Greenspan suggesting the US economy has a 33% chance of entering into recession it is worth considering whether this is a realistic prospect or just a controversial parting shot from the 81 year old former Chair of the Federal Reserve. Alan Greenspan is held in high regard as an economist, some even credit him with “saving the US economy”. However his track record on economic predictions is mixed. He did predict a dotcom bubble bursting, (although it was 4 years before it occurred)

Reasons why the American Economy may enter a Recession.

1. Falling House Prices. After several years of a booming housing market. House prices are now starting to fall in most US states. Falling house prices will have a significant impact on consumer spending. As house prices fall, people can no longer remortgage to have extra capital to spend. Also falling house prices have a significant impact on consumer confidence. As housing is the biggest form of wealth it will adversely impact on the financial situation of most households. [1] America's past growth has been maintained by strong consumer spending, if this falters economic growth is likely to do the same.
   

2. House Prices could have further to fall. Looking at historic house price to earnings ratios the average US house price has been overvalued for several years. For the house price to earnings ratios to return to normal, house prices may have to fall by more than 18%. [2] Note the Japanese housing market provides a recent precedent for those who don’t believe house prices can fall for a long time.

3. Mortgage Lenders going Bust. Due to a record levels of default on sub prime mortgages, the number of mortgage lenders going out of business is at an all time high. [3] This has also changed other financial markets attitude to risk. Banks and stock markets will be much less willing to lend on dubious terms. The net effect is that investment and consumer spending will grow much slower, or even start to fall.

4. Current Account Deficit. The US current account deficit is currently 6.5% of GDP. [4] For a long time some economists have said there is nothing to worry about. The deficit has been financed by Chinese investors willing to buy US assets, even with a relatively low interest rate. However increasingly Chinese and Asian investors are seeking to diversify out of the US dollar. The dollar is losing its “safe haven” status. Partly because of events in Iraq and Afghanistan but also because of a realisation that the US economy is not as dominant as it used to be in the past. If the Chinese start buying less US securities it will cause a further devaluation in the dollar and also require higher interest rates to attract people to buy sufficient US securities. The higher interest rates will exacerbate any fall in US consumer demand.

5. Budget Deficit. The US has a twin deficit. As well as a balance of payments deficit. They also have a budget deficit. The effect of this is that it puts upward pressure on interest rates. Higher interest rates are required to attract investors to buy bonds and securites. Having such a large deficit also leaves the government less room for manoeuvre in terms of expansionary fiscal policy. If the US economy does start to slow down there is little scope for further tax cuts and increases in government spending.

6. High levels of debt. High levels of debt make the US economy susceptible to increases in interest rates. Higher interest rates may be necessary because of the twin deficits and falling dollar. Even a small rise in interest rates could have a significant adverse effect on heavily indebted consumers.
   
   
7. Falling Stock Market. By itself a falling stock market doesn't cause a recession, but it is indicative of the change in confidence and mood of the US economic situation that US share prices have fallen sharply since last week.
   

Reasons why the US economy may not enter recession.

1. High Economic Growth. Economic growth is still positive and inflation is under control. Current economic statistics are generally good, despite growth being revised downward. The Fed still expects growth of 2.75% - 3% next year

2. The Global economy is no longer dependent on US consumers. Economic growth in Asia<