Readers Question I am currently trying to understand the policy options available to the UK Government given the large UK Current Account deficit. Do you have any articles specific to this area that I could read or even if you could reply briefly with your opinion of the policy options available to the government it would really help me in my understanding.

It's an interesting question. The first issue is should the government worry about the UK Current account deficit in the first place?

There was a time when a current deficit of 2% would be seen as a damaging economic problem, it could even become a political issue. But, these days, should we care if we have a current account deficit? (The UK current account deficit is currently close to 5% of GDP - a record figure)

Reasons not to worry about Current Account deficit

The argument is that in recent decades, due to globalisation, there has been an improvement in capital flows which make it much easier to finance a current account deficit. It is also worth bearing in mind there are two main ways of financing a current account deficit.

1. Short term Capital flows - buying UK bonds, securities and other financial derivatives
2. Long Term Capital flows - Foreign Firms e.g. Japanese firms investing in a new Nissan factory in the North East.

We could make the argument that if we buy Chinese goods, and the Chinese are then happy to use the foreign exchange reserves investing in the UK, what is the problem?

Reasons to Worry About a Current Account Deficit

However, there are reasons to worry about a current account deficit, especially when it starts to reach 5% of GDP. These reasons are:

1. It does become difficult to attract sufficient capital flows, and when this happens it invariably causes a depreciation in the value of the Pound. (depreciation can lead to inflationary pressures e.t.c)
2. It means the UK economy becomes reliant on the strength of foreign countries.
3. It indicates an unbalanced economy. - Relying on consumer spending and weak in the exporting manufacture sector.

There is a lot more to this issue. However, it is worth bearing in mind when we look at the issue of how to reduce a current account deficit. This is because if we are not convinced it is a real problem some solutions will not be worth pursuing, because the costs are greater than the benefits.

Solutions to a Current Account Deficit.

1. Slowdown Consumer Spending.

The best way to reduce imports is to reduce consumer spending and boost the savings ratio. The Government could increase taxes and reduce government spending (deflationary fiscal policy). This will reduce consumer spending. This will be effective in reducing the current account deficit because the UK has a high propensity to import. (about 40% goes on imports)

• However, to reduce consumer spending will cause a fall in economic growth and higher unemployment. So it is rather a drastic policy.
• The government may not need to reduce consumer spending as the economy is predicted to slowdown in 2008. This slowdown should reduce the current account deficit.

2. Boost Productivity.

In the Long term the government could try and increase the productivity of industry. This will enable UK exports to become more competitive helping to increase exports and reduce the attractiveness of imports. To increase productivity the government can implement supply side policies such as:

1. Better education and training
2. Privatisation
3. Investment in transport / infrastructure

Of course supply side policies are easier to say than do. Every government will say they are trying to increase productivity. But, in reality there is only so much government policy can do to increase productivity of industry. Even successful supply side policies will take a long time to have any effect.

3. Devaluation.

The obvious solution for a current account deficit is to devalue the currency. This makes UK exports cheaper and imports more expensive. This should improve the current account deficit.

However,

• How exactly does the government devalue the exchange rate? The exchange rate is determined by market forces not the government. True the government could sell pound reserves, but, this is only a fraction of the market these day. Lower interest rates would weaken the currency. But, interest rates are set by the MPC and their target is inflation not the current account deficit.
• Furthermore demand for UK exports has become more inelastic therefore the boost in export value may be quite limited.

Conclusion

To be honest there is not that much the government can do:

• Deflating the economy doesn't make sense
• Supply side policies are all very well, but they are not really going to make much difference in the short term.
• My feeling is that the UK economy has become unbalanced; due to the housing boom and willingness to borrow on credit, the UK has become a nation of consumers and importers. Our savings ratio is low and this is reflected in a current account deficit.
• However, a part of the current account deficit (and it is hard to say how much) is not a problem and merely reflects the fact the UK has a comparative advantage in attracting capital flows and is not particularly good at manufacturing any more.
• I doubt the government will do anything specific to reduce the current account deficit. But, the slowdown in the economy during 2008 should help reduce the size of the deficit.

Related

• UK current account deficit 2008
• Reasons for UK Current account deficit
• Does a Current Account deficit matter?
  

See also: Tax on fatty foods

Last night I watched an inspirational tv programme "lose 30 stone or die" . It was about a guy, Colin who weighed 48 stone (672 pounds) and was told by his doctors he needed to lose 30 stone or he could die in the next year. He manage to lose 10 stone and then qualified for an operation to have his stomach stapled. With his stomach stapled he was able to continue his weight loss and keep the weight down. By the end of the programme he had achieved his goal of losing 30 stone (although he had a huge amount of skin and fat left over). It would have been interesting to see what happened next.

At one point the NHS said they were not going to pay for the £10,000 operation. The NHS said he was able to lose weight on his own. However, Colin was devastated about this because he worried without the operation is weight could easily go up again.On appeal his family were able to overturn the decision and Colin was given an operation to have his stomach stapled.

Does it Make Sense to Pay for People to Lose Weight?

Many argue, well they are fat because they eat too much - why should the government pay for operations and even worse give them money, when they should solve the problem themselves?

When making a decision like this, we need to work out the economic cost of obesity.

When Colin was 48 stone, he was a burden on the taxpayer. He didn't pay taxes, but received incapacity benefits. After losing 30 stone, he is physically able to get a job and therefore no longer such a burden on the taxpayer. This means the cost of the £10,000 operation can effectively be recovered within 12 months of working. Clearly there is an economic incentive for paying people to have an operation if it means they can keep to a target weight. From an economic point of view, we don't need to worry about whether people deserve an operation or whether there are better operations. If the government can recover the cost of the operation within a short time period it is a good investment for the tax payer. (There are also other costs to take into account; if you are chronically obese, you are more likely to be ill and therefore a drain on NHS)

There have also been some suggestions from the government that fat people should be given monetary benefits as an incentive to lose weight. Should we Give benefits to those who Lose Weight?

This might sound more contentious. After all why should fat people be given money for doing something they should do anyway. However, if it leads to the same kind of economic advantages as mentioned above, maybe it can make sense, even if it doesn't appeal to our sense of fairness and what is right?

Maybe we need a combination of both higher taxes on fatty foods and fiscal incentives for losing weight. The danger is the Government could become a 'nanny state' but the benefits are overcoming the obvious market failure of obesity.

See also:

• Arguments for a Fat Tax

The potential negative effects of global warming are very serious. Even by just concentrating on economic factors, global warming has the potential to cause unprecedented costs to the global economy (According to Stern Report 20% of global output could be lost over the next few decades) (1). Yet, despite the forecasted dangers and economic costs, there seems to be an inertia in implementing necessary policies to avert the consequences of global warming.

These are some of the reasons why it is difficult to deal with the issue of global warming.

Free Rider Problem.

Global warming is by definition a phenomena which affects every country. Pollution may be caused by a small % of developed countries and yet those who suffer the most may be pacific islands who contribute nothing to global warming. When it comes to reducing carbon emissions there is a classic free rider problem. Countries can benefit from lower emissions by relying on other countries to make sacrifices and reduce their pollution levels. The problem is that countries can then become reluctant to start reducing emissions until other countries start reducing emissions as well. Why should a tiny country like Sweden make sacrifices in reducing carbon emissions, if the US continue to create 25% of the world's CO2 emissions?

Externalities.

Global warming is to a large extent caused by externalities. When you drive an SUV, the contribution to global warming is an external cost which you don't experience personally. Free markets are notoriously bad at including external costs in prices. The consequence is that there is over consumption of goods which pollute and cause global warming. In theory economics has a solution to the problem of externalities. If you can work out the external cost of driving an SUV, you can place a suitable tax to make people pay the social cost and reduce demand to the socially efficient level. The difficulty is working out and then agreeing on a suitable external cost. If the real cost of global warming is as high as the Stern report indicates, it would suggest carbon emitting vehicles are seriously undertaxed and the social cost of carbon emissions is much higher than current legislation suggests. The difficulty then also becomes convincing the general public that due to the external costs of pollution we need a 100% increase in petrol tax.

Intergenerational externalities.

Another problem of global warming is the issue of intergenerational externalities. The current population is benefiting from the consumption of fossil fuels and is unlikely to face the worst consequences of global warming. The problem becomes trying to reflect future costs in today's prices. This is one area where policy makers and economic theory has placed very little emphasis in the past. The traditional economic models consider issues as being static, and tend to place less emphasis on activities which increasingly create costs in the future.

The economics of Uncertainty.

Another problem with global warming is that there is tremendous uncertainty about the future costs of global warming. The Stern report suggested a particular economic cost but in reality it could be less, but, it could also be a lot more. For every report which suggests global warming will be a real problem, it will always be possible to create an alternative report, (perhaps by people who don't really want to accept the potential cost of global warming.)

However, given the uncertainty of global warming the rational solution would be to risk averse. i.e. assume the worst and take steps to avoid it. Instead people seem to prefer to take the risky option of assuming that the outcome may be much better than many reports predict; if this is the case then future generations will not suffer; but, if our gamble is misplaced future generations will bitterly regret the decisions of the present generation. This risk taking approach to global warming goes against what we see in usual rational behaviour. For example, people take out home insurance to protect against the (very small ) risk of a house burning down. On a global scale, we have quite a high risk of serious global disaster, but people are very reluctant to take the necessary steps to avoid it.

How Could Economists help in Changing Attitudes to Global Warming?

• Emphasise the nature of Market failure for this particular issue.
• Explain the importance of external costs in justifying higher taxes on carbon emissions and corresponding subsidies for alternatives.
• Place greater emphasis on intergenerational economic issues.
• Critique of old growth paradigms which equate improved living standards to increased GDP
• Emphasise the rationality of insuring against worst possible outcomes rather than risking the chance that the worst will not happen.
• Emphasise why countries should act, irrespective of the decisions of other countries.

More on Economics of Global Warming

Is global warming happening in the UK?

References:

(1) Stern Report on Global Warming

Suppose there is a game where I am selling a £10 note. I will sell it to the highest bidder. The only problem is that if you make the second highest bid, you have to forfeit that amount to me.

The first bidder could offer 1p for the £10. He has nothing to lose and the chance to make £9.99 profit. However, a second person may then think that they might as well bid 2p. It is still remarkable value for a £10. Furthermore, if he ends up losing 2p, it doesn't matter, as it is not worth anything.

However, the bidding process may keep going on. In one sense it is rational to keep offering a higher bid, when there is chance to buy a £10 note for less than £10.

However, when you get to £9.99 what happens next?

Well the person who bid £9.98 is on the verge of losing £9.98 something he doesn't want to do. The rational thing for him to do is to bid £10. As this will save him losing £9.98. However, the person who bid £9.99 doesn't want to lose his £9.99 either. Therefore, it is rational for him to bid £10.01. The problem is then that neither bidder wants to lose their stake, therefore, the rational thing is to keep bidding higher, hoping that the other person will drop out. It is always best to win, because you at least get £10. It makes no sense to drop out because you will have to pay the losing bid and not get the £10.

The question is who will drop out first? At Sometime people will make a seemingly irrational decision to drop out. They can see the problem will escalate and so they might as well cut their losses. The question is when do you drop out of the bidding process at 2p, £9.99 or £19.99? From an economic point of view it represents an interesting investigation of human behaviour because ultimately people will choose to do something which is seemingly irrational, but from their perspective makes sense.

Is there any point in getting involved in the game at all?

But, if nobody else joins, you might be able to win a £10 with a 1p offer.

Will this tempt others to join in?

It becomes a little like poker, who has the greatest nerve? In economics we can analyse decisions like this through game theory. The important thing here is your decision whether to bid higher, depends on how others respond. If you think others will soon drop out, you should bid higher, if you think someone will be determined to get the £10 note there is no point in continuing.

OK, who would like to start the bidding at 1p for a brand new £10 note?

We have become so accustomed to hearing remarkable stories about Chinese economic growth, that it becomes tempting to assume this is something that will continue forever. However, the increasing rate of Chinese inflation, could suggest that the economy is perilously close to entering a boom and bust economic cycle. This would be disastrous for an economy already struggling with disguised unemployment and rising inequality.
Recently Chinese inflation rose to 7.1%; mostly caused by rising food prices.

In this short post, I examine what China needs to do to avoid inflation getting out of control.
Although Unemployment is a problem in China, I don't feel the long term solution is to enable the economy to grow too quickly. Whatever the problems in the agricultural sector, the first priority should be to provide a framework of low inflation. If this means reducing economic growth from 10% to 8%, then that is fine.

The problem with the Chinese economic growth is that increased living standards have only been achieved by a certain proportion of the population. The rise in inequality could possibly spark social unrest as the gap between the haves and have nots increases.

The food inflation is particularly a problem because it hits the poorest hardest.
The Chinese government face the difficult, although not impossible, challenge of redistributing the fruits of economic growth. To do this it may require a new strategy for dealing with the declining agricultural sector

These are some essays on inflation and unemployment I have written in the past year or two. When I first started studying economics in the 1980s, both inflation and unemployment were considerably bigger problems. Nowadays, we get worried if inflation is forecast to rise to 3%. Yet, in the 1980s, inflation of 3% would have been seen as a remarkable achievement. Similarly unemployment has fallen quite markedly since the high levels seen even during the Lawson boom. Part of the reason may be people are simply receiving different benefits. But, employment levels are at record highs and firms do mention difficulties of employing workers in certain areas.

It is easy to focus on the negative in economics, but the reduction in unemployment and inflation in the UK and other countries should be cause, for at least some collective pats on the back.

Inflation Essays

• Discuss the Difficulties of Controlling Inflation
• Does Devaluation Cause Inflation
• Should the Aim of the Government be to Attain Low Inflation?
• Explain What Can Cause a Sustained Increase in the Rate of Inflation
• Reasons for Low inflation in the UK
• Inflation Explained

Unemployment Essays

• Explain what is meant by Natural Rate of Unemployment?
• What Can Cause Natural Rate of Unemployment to Change over time?
• Should the Main Macro Economic Aim of the Government be Full Employment?
• What is the True Level of Unemployment in the UK
• What explains low inflation and low unemployment in the UK?

More macroeconomic essays

Payday loans involve very short term cash loans at very high interest rates. For example, National Payday loan company offer this loan:

• To borrow $100.00 for 7 days incurs a charge of $25.00 (25%). Therefore the customer has to repay $125.00 which works out at an APR of 1303.57%

This interest rate far exceeds any standard interest rate. For example, the interest rate on a simple bank loan could work out at around 8%. Therefore, why would anyone be wiling to pay what is effectively an interest rate of 1303.5% ?

1. Lack of Knowledge. Someone taking out a loan may not think in terms of APR. They may not even know what APR interest rate is. A consumer may think it costs $25 to borrow the amount I need and they are willing to pay the cost to avoid other problems. To be fair, companies do publicize APR on their website but it is possible customers may not fully appreciate their significance.

2. Poor Credit History. Many people who take out pay loans, presumably are ineligible for other types of borrowing. For example, immigrants or people with poor credit may simply be refused all other types of bank loans and credit cards. The number of people in this category is much higher than we may imagine. Therefore, payday loans may be the only available option. The alternative to taking a payday loan may be either defaulting on other payments like rent or going to an underground loan shark. However, most Payday companies require customers to have an active bank account before being eligible for a payday loan

Problems of Payday Loans.

The problem with payday loans is that when you start paying fees of $25 for $100 loans, your finances deteriorate rapidly. Paying such high fees mean that in the future it will become more difficult to meet loan repayments, therefore a single payday loan can start a vicious cycle of debt that is hard to get out of.

Benefits of Payday Loans

Better than the alternative of missing payments and getting a bad credit rating (although if people already have a bad credit rating this may not be such an issue)

What should governments do About Payday loans?

To overcome market failure the governments should

• Improve personal finance education. Making people aware of a range of financial products and the implications of things like APR.
• Consider offering government backed loans to people with poor credit histories. The government doesn't have to do this out of charity. It could charge competitive rates of say 10% APR. However, the point is the government can include people into the financial system who are currently squeezed into very poor financial deals.

It is interesting to see the almost unanimity across the American political spectrum about the need for tax cuts. Americans seem to talk of tax cuts so frequently it is surprising they still have any taxes left to cut.

These are some of the benefits of Cutting Taxes:

1. Expansionary Fiscal Policy.

With falling house prices, there has been a marked slowdown in consumer spending, this could lead to recession and rising unemployment. Therefore, the main reason for the current tax cuts, is the necessity to increase consumer's disposable income and boost economic growth. This is good old fashioned Keynesian demand management. Although Bush, may not label himself a Keynesian (I wonder if he knows what a Keynesian is) that is precisely his philosophy.

2. Increased Incentives to Work.

It is argued that lower income tax and lower business tax can encourage people to work longer hours and business' to invest. It is a simple argument that if wages are higher they will substitute leisure for work. However, despite many people trying to exaggerate the importance of this argument, there is little empirical evidence that tax cuts do actually increase incentives to work. If income tax was over 60%, I think tax cuts would increase incentives, however, with income tax at current levels, cuts in the basic rate would have little effect. (this is partly due to the income effect, with higher wages, people can work less and earn their target income)

3. Boost Confidence.

Stock markets are falling on forecasts of a recession. Cutting taxes increases confidence that the economy will avoid a recession.

These are the main arguments for tax cuts, but, are they really any good in practice.

Arguments against Tax Cuts

1. Demand can be managed by Monetary Policy.

With the Fed cutting interest rates by 1.25% in the space of a few weeks, is there really any need for an expansionary fiscal policy as well? It could be the case the US economy is stimulated too much, causing inflation.

2. The American Economy is Unbalanced

The American economy has long been skewed towards relying on consumer spending to boost growth. This has resulted in record low savings ratios, high current account deficit, record levels of consumer borrowing and excessive risk taking. By cutting tax, the government is trying to mask the underlying problem without solving the causes of the weakness. Although, it may cause lower growth, America may need a period where consumer spending takes a lower priority. This would help reduce the current account deficit, boost the savings ratio and stimulate long term investment. It is even argued that the reflationary fiscal and monetary policies can be seen as pandering to the bad economic decisions of reckless borrowing and investment.

3. Government Borrowing.

US national debt is currently 65% of GDP (under $10,000 billion). In a downturn, we expect borrowing to increase and get worse; however, with such a large fiscal deficit, the government should not be so keen to exacerbate the deficit more than necessary.

4. Will Confidence really be restored?

It is a matter of debate whether a tax cut will really restore confidence. The expansionary measures have a touch of panic about them. The consumer may feel that prospects for growth are still low, and therefore, they will choose to save the tax cut making the expansionary fiscal policy have little effect.

5. Tax Cuts will not solve the problem in the Housing Market.

The real problem facing the US economy is the defaults from the subprime crisis and the problem in the housing sector. These problems will not really be solved by cutting income tax. The cuts in interest rate will have the biggest effect on easing mortgage interest repayments.


Problems with US Economy

Given recent economic events, it would have been a real concern if the US trade deficit had not posted a marked improvement. The data from the US commerce department said the trade deficit contracted by 7% last month to $59bn (£30bn), the biggest monthly fall in more than a year.

The trade deficit totalled $711.6bn for all of 2007, down 6% from the record set in 2006. It is the largest annual percentage drop since 1991.

The main reasons for the drop in the deficit includes

Devaluation of the Dollar. Falling dollar has made US exports appear more competitive
Strong Demand from East. Despite talk of a global slowdown growth in other parts of the world is still strong
Falling consumer confidence. Due to weakness in the housing market, US consumer spending is showing less strength than previously; this is helping to limit the growth in imports.

The US has a significant deficit just due to oil imports. If the price of oil had not risen so much in 2007, the deficit may have been even less.

The falling trade deficit may help improve prospects for the dollar and future US economic growth.

US Trade deficit

Economists have a certain world view. Their economic training gives a different insight into issues that non economists might not appreciate or consider important. These are few examples of different approaches to economic issues. There are other examples of differences and perhaps these differences are not as significant as we might imagine; I would be interested in hearing the view of both economists and non economists (assuming of course a 'noneconomist' would read an economics blog..)

Rational / Irrational

Economic theory assumes people are rational and will make rational choices. Yet in the real world people often make decisions which can only be viewed as irrational from an economic perspective. E.g. Why would people choose to take out pay day loans at an interest of greater than 2,000% apr? Why would people pay more for a product that is identical to another cheaper product? This is perhaps a big difference, but also highlights a limitation of economics. This limitation is examined in behavioral economics

Opportunity Cost

When watching a political debate or the views of voters, it always strikes me how little people consider the idea of opportunity cost. You can frequently here people say 'The government should save this hospital' 'The Government should provide more public transport' 'The government should reduce that tax'. However it is very rare that a pressure group or non economist will offer a way of funding the spending or tax cut; people often forget the opportunity cost of any economic decision.

e.g. how often do you here voters of politicians argue 'The government should increase spending on public transport; and this can be funded by imposing a political unpopular tax on cars. Furthermore, this tax is likely to overcome external costs and improve social efficiency.'
For an economist any decision on the governments budget imposes an unavoidable opportunity cost. Increase spending will lead to either higher tax or more borrowing. Non economists often forget the opportunity cost of economic choices.

Statistics vs Personal recollections

Non economists tend to put a greater emphasis on personal experiences and every day events. For example, many in the US feel the economy is already in recession because of the bad news on housing markets, subprime crisis and perhaps a personal experience of someone losing a job. An economist would be wary of giving importance to one off factors because they can give an inaccurate reflection of the overall picture.

Exaggeration

The media often seek to exaggerate the 'housing crisis' and 'rocketing' price levels. For example, in the UK, newspaper headlines have recently focused on 'The biggest house price fall for 15 months' This sounds more impressive than another headline, which is perhaps more accurate . 'Monthly house price figures show annual rate of House price inflation falls from 6.5% to 5.3%' Both headlines are correct in some way; but arguably the first headline emphasises a certain aspect of the statistics for greater 'shock value'. Of course, this is not to say economists can't use statistics for exaggerated effect; I'm sure readers could give numerous examples. But, perhaps non-economists are more likely to use misleading statistics, especially in the media and political world.

Certainty vs Uncertainty

The joke goes, put 10 economists in a room and you get 11 different answers. If you are wondering where the actual punch line is, don't worry - it's not that funny. But, the point here is that economists are trained to see both sides of the argument. For every statement a good economist will feel obligated to add numerous caveats and other potential outcomes. A recession might occur, but it depends on X,Y,Z. A non economist is more likely to see issues in black and white. The economy is messed up - We're heading for a recession.

Externalities

On the issue of imposing taxes on negative externalities, economists will justify tax and subsidies based on the issue of externalities. For example, an economist would say a congestion tax is justified because it internalises the external cost of driving into a city centre. Externality arguments can often be difficult to explain to non economists. If you mention a congestion charge to an average voter, there instinctive reaction would be 'not another tax on the motorist' 'this tax is unfair on low income groups'. This is not to say non economists cannot think in terms of externalities, but generally this is a low priority or doesn't immediately spring to mind

I got the inspiration to write this post after reading:

• Are Externalities a bridge between them and us
• Market Failures and making economics loveable

See also:

• Economic mistakes of politicians
• 7 Common economic fallacies

There is an important difference between UK monetary Policy and US monetary Policy. The Federal Reserve has been given a target of low inflation and full employment. The MPC, in the UK by contrast, have only one objective - low inflation; CPI inflation of 2%.

Recent events show the difference in attitudes to Monetary Policy. In the US, concerns over falling stock markets and impending recession, caused the Federal Reserve to cut rates by 1.25% in the matter of weeks. The MPC, by contrast took a much more conservative approach cutting rates by 0.25% and adding that it still remained concerned about inflationary pressures.

Of course there are differences, US house prices are falling faster and for a long time; the prospect of recession is more significant in the US than the UK. However, if you have an objective of achieving full employment then it makes it easier to justify big rate cuts like in the US.

Advantages of Targeting Inflation and Full Employment

• If you only target inflation, then there is a risk that you can cause a slowdown. Low inflation on its own isn't the only important objective.
• Inflexible. Suppose there was a rise in cost push inflation. This would cause higher inflation and lower growth. (AS curve shifts to left). The MPC would be mandated to effectively increase interest rates to keep inflation low. However, this rate increase may be inappropriate and tip the economy into recession. The US, by contrast would have the flexibility to allow a higher rate of cost push inflation and avoid a significant fall in growth.

Problems with US system of Targeting both low inflation and full employment.

The Federal reserve can be criticised for responding too hastily to falls in financial markets. In 2002, the Fed cut interest rates to 1.5% in response to falling markets, arguably this created a credit and housing bubble. If they had sought to control the housing and credit bubble, rather than panicking about full employment they may have enabled a more stable period of economic growth.

There is also a criticism that by cutting rates so quickly they are throwing a lifeline to financial institutions which were reckless in lending bad credit without proper safeguards. If the Fed, try to dig bad lenders out of a hole. There is an argument it will create moral hazard and encourage future bad loans.

Low Inflation is the best long run Strategy for Full employment.

• It is argued that if you create a low inflationary environment it provides the best solution for full employment. Low inflation enables.
• Growth to be close to the long run trend rate,
• Encourages investment through encouraging stability.
• The experience of the UK economy since independence of the MPC in 1997, suggests that the UK strategy has been successful in maintaining both low inflation and full employment.

I think both can work. Often it comes down to making the right decisions rather than the framework. However, if there was a change in global economic conditions, I would be concerned about the UK's policy of targeting only inflation. There is a lack of flexibility in only targeting inflation. Hopefully common sense would prevail and the MPC would take into account the effect on growth and employment.

Related Essays

• Should the Government's Primary Objective be Low Inflation?
• Should the Primary objective of the Government be Full Employment

It is argued by some people that a recession can benefit the economy, at least in the long run. The reasoning is that falling revenues force firms to become more efficient, e.g. cutting unnecessary costs e.t.c. In a recession, inefficient firms will go out of business and this shake up is necessary to weed out the inefficient and provide incentives for firms to be as profitable as possible.

This belief was articulated by the Chairman of Ryanair, Michael O'Leary's recently, arguing that a recession would be a good thing. see Guardian article

However, is this a good argument?

Problems of Recession - Why A Recession is Bad

1. A recession will make it difficult for new firms who have just entered the market. Most new firms have high set up costs, therefore, a downturn in the economy could make them close down. However, this does not mean that they are inefficient. It just means they are new and struggling to get established..
2. Increased Monopoly Power. If a recession causes the smaller and newer firms to go out of business then the larger dominant firms will gain more monopoly power. In the long run this will lead to less choice and higher prices. This is a definite disadvantage of a recession. When the Chairman of Ryanair argued recessions would be a good thing, maybe he meant - a good thing for Ryanair, as it may involve new firms going out of business leaving him more market power.
3. Hysteresis. This is the argument that the past is a predictor for the future. Basically, if you have high unemployment, then it is more likely to have high unemployment in the future. If people are made unemployed in a recession, it may take a long time for them to find work again. When they are unemployed they lose skills, become demotivated and become less attractive to employers. Note after the recession of 1981, Unemployment remained stubbornly high in the UK, even into the boom years of the late 1980s
4. Fall in Productive Capacity. A recession can damage the productive capacity of an economy. Firms can go out of business and therefore shut down their resources. Furthermore in a recession, there will be a significant fall in investment, this can harm the long term development of an economy.
5. You don't need a recession to weed out inefficient firms. If markets are reasonably competitive, inefficient firms will be forced out of the market anyway.

Conclusion:

A recession is unnecessary to increase economic efficiency. The long term future of an economy can be best helped through stable growth, which avoids the extremes of boom and bust economic cycles.

Definition of Recession

Labels: recession

Politicians are very rarely economists. Economists very rarely become politicians. Our elected officials often make serious economic mistakes due to political pressures which often work against sound economic sense. These are some of the most common economic mistakes.

Boom and Bust Cycle.

Generally, politicians do better when growth is high and unemployment is falling. Therefore, in the lead upto elections, there is a clear incentive to stimulate the economy through expansionary fiscal and monetary policy. E.g. cutting taxes and cutting interest rates. However, the problem is that politicians can easily go too far; they allow demand to increase too much and this causes inflationary pressures to increase. This leads to a boom and bust economic cycle. See Lawson Boom of the 1980s. It is mainly for this reason that monetary policy is now operated by independent Central Banks, - taking away the temptation of politicians to meddle in the economy.


2. Increasing National Debt.

There is a clear political incentive to cut taxes and increase spending. The result is that government's invariably create budget deficit's. This needs to be financed by borrowing from the private sector. The long term consequence of higher borrowing levels are unnecessarily high levels of interest payments. In the UK, £30billion a year goes on interest payments servicing the national debt. If the government had not built up debt in the past. Taxes could be cut quite significantly.

The problem is who is going to vote for the candidate who promises to cut spending and raise taxes?

3. Increasing Complexity

Politicians often want to do something which creates positive headlines, so they introduce a new tax and benefit which sounds good. The consequence is that the tax system becomes very complicated with many loopholes and different levels to deal with.

4. Affect on Incentives.

Politicians often look for short term fixes without thinking of the long term consequences. A good example is in the UK, the government were criticized for only increasing old age pensions by 75p a week. Therefore, they introduce a Minimum Income Guarantee for pensioners. This could be used to say they were reducing pensioner poverty and increasing their incomes.

However, the long term consequences of this policy are not good. Basically, it rewards people who do not save for a private pension. If you save for a private pension then you could end up with the same take home income as someone who didn't bother saving but then benefited from the governments minimum income top up. A better solution would be to increase the basic rate of pension or provide additional benefits to those who get a small private pension.

Who Wins and Who Loses From the Depreciating Dollar?

An interesting piece here by Reuters showing that the Euro is now being accepted in New York shops. Euro accepted in New York

This is mostly a symbolic reflection of the declining power of the dollar. It also illustrates how attractive American goods have become to Europeans.
Because of the Dollar's weakness, European consumers can pick up many bargains by buying goods in the US. Especially, for electronic goods, Europeans can make savings of upto 60-70%. Although a falling currency often injures a sense of national pride; it is worth asking is a weak dollar really a big problem for US?

Benefits of A Devaluation for the US.

1. Boosts Exports. The devaluing dollar has given a much needed boost to the US export industry. The export sector is one of the best performing parts of the US economy, creating jobs and boosting domestic demand.
2. Reducing Current Account deficit. 12 months ago, the US were facing a current account deficit of over 6.5% of GDP. In the past few months, the devaluation of the dollar has helped to reduce the current account deficit to only 4.8%. (Although, one does have to wonder how far the dollar would need to fall to eliminate the current account deficit)
3. Boost Economic Growth. With the US housing market experiencing severe problems such as falling house prices and rising repossessions, there are widespread fears the US could enter into a recession. The boost from net exports could be a significant factor in maintaining rates of economic growth.

Costs of Falling Dollar

1. Inflation. The main worry of a depreciating currency is the impact on inflation. Depreciation causes inflation because:

• imports more expensive
• Rising AD
• Exporting Firms have less incentive to cut costs

However, the depreciation in the currency comes at a good time. Because of the slowdown in economic growth, inflation seems to be the least of the US's concerns. The Fed illustrated this by cutting interest rates by 1.25% in the past couple of weeks. Therefore, inflation is not really a problem

2. More expensive imports. the depreciating dollar is certainly bad news for American consumers and American tourists. They have found that a weak dollar is no joke when you go on holiday to Europe. However, given the low savings ratio and high trade deficit, perhaps it is good that American consumers lose their attraction for consuming so many foreign imports.

A continual depreciation in the US dollar will reduce living standards in America; there is also the possibility of declining competitiveness in the long term. However, the depreciation has come at an opportune moment. With the prospect of recession and large current account deficit, the weak dollar is ironically helping to make the US economy stronger. Although it is worth pointing out, it is making the economy stronger from the demand perspective; it does nothing to address the underlying problems facing the US economy.

Related essays on the dollar

• Will the dollar continue to fall?
• How a Falling dollar affects US and global economy
• Predictions for US Dollar

Why Has China such a large current account surplus? China's current accounts surplus is nearly 11% of GDP or $250bn. This surplus is entirely due to its trade surplus of $261. Current account is composed of trade in goods (Trade balance) and trade in services.

The size of the Chinese current account surplus is really quite staggering; I'm not sure if it is a record, but I wouldn't be surprised if it was. These are the reasons for the current account surplus.

Reasons for Current Account Surplus

1. Undervalued Yuan.

It is argued by many, that the Chinese Yuan is undervalued making Chinese exports relatively more competitive and imports cheaper. This is a significant factor in making the terms of trade favour a surplus. The reason the Yuan has been kept undervalued is that the Chinese government are keen to promote exports as much as possible. They feel strong growth in the export sector is vital to creating employment and soaking up unemployment created through privatisation and decline of agriculture.
Nevertheless, the Chinese Yuan has appreciated 20% in the past 2 years, as the Chinese government slowly allow the Yuan to appreciate.

2. Comparative advantage in manufacturing exports.

China has been able to grow at a fast rate because it has been able to keep exports comparatively cheaper than elsewhere in the world. China's elastic supply of labour have enabled wage rates to remain low, giving China an advantage in the producing goods at a low cost.

3. High Domestic Savings Rate.

Despite the high rates of Chinese growth. The Chinese economy has a very high savings rate. 40% This means consumers are saving rather than spending on foreign imports. Rather than buy consumer goods, the Chinese are preferring to invest in foreign securities. e.g. buying US securities and bonds. This outflow of Capital has financed the US current account deficit; in the process China has built up an impressive amount of external assets.

Related articles

• Does a current account deficit matter? - does a current account surplus matter?
• UK Balance of Payments 2008

If you study economics, you will know that a cut in interest rates should cause a devaluation in the exchange rate. The reason is that lower interest rates, make it less attractive to save in the country therefore there will be less hot money flows and lower demand for the currency. This will cause exchange rate to fall. However, in the real world, we often see that the theoretical outcome doesn't happen.

For example, the Fed have cut US interest rates by 1.25% in the space of a few weeks. This is the equivalent of five 25 basis point cuts. Yet, since that period the dollar has hardly lost any value at all.

Why has the textbook explanation not proved to be correct?

• The reason is that markets usually are predicting what will happen in the future, rather than just responding to current events. For example:
• The markets may have anticipated the rate cuts in advance. Therefore, people would have sold dollars in the past. Therefore, when interest rate cuts occur, they have already been built into the price of the dollar.
• The Interest rate cut alters the future prospects of the US economy. The dollar's weakness was partly related to the prospects of a US recession. These rate cuts have diminished the potential for recession. Therefore, speculators are more optimistic about the future of the US economy and US dollar.
• Markets Don't believe the rate changes will last. When the UK was in the ERM in 1992, the government increased interest rates to 15% to protect value of Pound Sterling. However, the markets felt this interest rate increase was completely unsustainable and so they didn't buy pounds. They correctly predicted the government would have to soon reduce interest rates to prevent the recession get.
  

To summarise

Ceteris paribus, lower interest rates would reduce the value of an exchange rate. however, in the real world there are many other factors that go together to determine the exchange rate.

Recent Readers Questions on Economics Blog

1. Sub prime Crisis and global credit markets
2. Benefits of reducing the value of a currency
3. Does the size of a country affect the rate of Economic Growth

See previous post: The Lawson Boom 1986 -1990

By the end of the 1980s inflation was getting out of control (9.5% in 1990), and so the chancellor eventually persuaded Mrs Thatcher to join the ERM. In the ERM the value of the £ was kept within certain boundaries against the D Mark. However, with inflation increasing the £ became weak on the exchange markets. Therefore, the government were forced to increase interest rates to protect the value of the £ from falling.

Higher interest rates were helpful for reducing inflation. But, the problem was that because the government was targeting the exchange rate they increased interest rates by much more than was necessary to slowdown the economy. These increases in interest rates caused a big increase in the cost of mortgage payments, this led to home repossession and falling house prices. Falling house prices and lower spending caused the economy to slow down and enter into a recession. However, despite the economy entering into a recession, the government didn't cut interest rates. This is because they placed greater value on the exchange rate target than economic growth.

The markets believed the £s value against the D Mark was unsustainable given the recession. The market believed that interest rates of 15% were simply unsustainable therefore, foreign exchange dealers kept selling £s. The government responded by using foreign currency reserves to buy £ and keep interest rates high. The government were committed to maintaining the £ in the ERM, whatever the consequence. However, the problem is that the government couldn't buck the market. The market correctly predicted there was nothing the government could do to prevent a devaluation.

Eventually the government were forced to give up their misplaced efforts to maintain a high exchange rate. The UK left the ERM and interest rates were able to fall. The government felt it was a humiliation, but, it was just what the economy needed (if several months too late). The lower interest rates prevented the economy getting worse and helped prevent more home repossessions.


Mistakes of the Thatcher Government

1. Allowing the economy to expand too rapidly causing inflation.
2. Targeting the exchange rate, when this was detrimental to other more important objectives like preventing a recession.
3. Inflation should never have been allowed to increase so much, but when they tried to slow down the economy, they overacted making the recession deeper than it need to be.

As you might imagine Lawson and Thatcher were largely unrepentent. But, it was a clear case of economic incompetence. Why the Conservatives were rewarded with an election victory in 1992, will always remain a mystery to me.

Whatever you say about Labour since 1997, they haven't messed up the economic cycle as badly as the Conservatives did in the 1980s.

UK economy 1979-84 under Mrs Thatcher