The average petrol prices in UK have reached 109p a litre, one forecourt in Kent is charging 129p. The rising price of oil, petrol, diesel and Natural Gas (which is linked to the price of oil) have meant average consumers are paying more for energy bills than ever before.

The government has been criticised for the high rates of tax. Not only do the government place excise duty on petrol at (roughly 50%) of the price (see: Fuel Duties in UK and Europe), but they also receive VAT at 17.5% With the price of petrol increasing, the Government are making an estimated £123m more from VAT revenues.

However, if the Government were to cut fuel tax, they would have to make the shortfall up for elsewhere. The average consumer would not be any better off for a fuel tax cut; they would merely pay for the tax cut elsewhere.

Profits of Oil Companies.

• Shell and BP recently announced record profits. The figures are staggering.
• BP made an astonishing $73m (£37m) a day.
• Shell did better still, pocketing a cool $86m per day (that is $31,390m per year or $31.3 billion)

In their defence oil companies say:

• We make most of our profits in extracting oil. Profit at forecourts is relatively low
• We need high profits to discover new oil fields. This is becoming increasingly difficult with dwindling supplies.
• We pay alot of corporation tax already

However.

• The fact that they make most of their profits at the extraction level doesn't really matter. The oil companies merely use their market power to squeeze out competition from the petrol pumps. Because they have monopoly in the supply of oil, they sell petrol to petrol stations at very high prices, enabling the high profits. This means the profit margin at petrol stations is low, but this suits them because they have already made the extravagant profit and now they can keep competitors from petrol retail away.
• Profit is needed for the risky business of investment in discovering new oil supplies, but, not necessarily £37m per day. Most of the profit goes to shareholders not for investment.
  

Solutions?

• Higher rate of corporation tax for firms making more than £1billion a year. Like higher rate of income tax for high income earners.
• In the long term, we need to focus on alternatives to a petrol based economy. Using more renewable energy sources. We could also focus on more efficient transport such as public transport rather than cars.
  

What does it mean to be rich and what does it mean to be poor? When we think of a rich list, we instinctively think in terms of wealth. i.e. how much a person's assets is worth. See: top 10 richest people in the world list.

Yet, often when these reports are published, you will here the rich claim that they don't have that much money; ot at least it is not at there disposal.

However, when we define 'poor' we think in terms of income. An income below a certain level. But, not everybody with low incomes would be classed as poor.

• Wives of a rich husband.
• Students living with wealthy parents.
• Professionals with the capacity to earn a lot of money. e.g. Lawyers may leave university with debts and no current income, but you wouldn't classify a trained lawyer as poor.
• Old People who have paid off their mortgage. If you can live rent free and low expenses you can get buy on a small income quite happily.

Similarly people with moderate incomes can still struggle to make ends meet.

• For example, a single parent with 5 kids, large mortgage and council tax.

Implications of Difficulties in Measuring Poverty and Effective living standards.

• Minimum wages often benefit second income earners, e.g. students living at home, women with a partner earning more. Therefore, a minimum wage is limited in its ability to tackle poverty.
• A high salary is still compatible with low living standards. When I got my mortgage I was paying £1,000 in mortgage payments and council tax. This was more than 50% of my gross income!. A pensioner with a salary of £15,000 may appear to be worse off than a young person with income of £20,000. But rent can easily vary by £10,000 a year.
• Wealth inequality. There is a big advantage to owning a house in that you can earn effective rent from the asset. However, most people don't see a house in this terms. They just see it as wealth locked up in bricks. But, if you own a house and pay off the mortgage. You can live rent free; which could be equivalent to saving £10,000 a year in terms of less expenditure. When Looking at incomes we need to consider the ability to improve their earning potential in the future. E.g. do they have skills and qualifications to get a better paid job.

Related

• Causes of Relative Poverty
• Policies to reduce poverty
  

One feature of the recent housing boom were the constraints on supply that often existed, especially focused in certain areas. This meant that house prices rose rapidly, especially in some areas where house prices rose far above the National average. The reason is a classic example of self interest by existing homeowners.

If you live in a local community you have everything to gain by preventing new houses being built.

1. If planning restrictions occur then the shortage of supply will drive up prices. You will see a gain in wealth, and the only thing you need to do is prevent new houses being built.
2. Less congestion on roads and public amenities
3. Will be able to enjoy unspoilt views across the countryside.
4. Planning restrictions on building houses reduce the value of land. Therefore, other uses of the land in that area become more profitable.
5. Environmental arguments. In addition to these reasons, supporters of planning restrictions can also use environmental arguments e.g. protect green belt land. These arguments are not without merit; nobody would want to see England covered in concrete. But, often environmental arguments can be used as a mask for the real reason which is desire to see house price rise. It is possible to build houses without destroying too much green belt land.

There is a strong political bias to planning restrictions. Existing residents are the ones who are voting. Other people who would like to come into the community, cannot vote in these local elections. Therefore, the electoral process will invariably support the candidate who supports planning restrictions. They may be a small % of first time buyers who would like more houses being built. But, the majority of the electorate are already homeowners and so object.

It is local politics that explains why it is so difficult for the government to meet its national target of building more houses. Everybody agrees we need to build more houses, it is just that we don't want them to be built in our local area. ( a similar idea to nuclear power).

Related:

• Overvalued Housing Markets
• Problems in UK Housing Market
• Booms and Bust in US Housing Market
  

Yesterday, Hometrack announced that year on year, annual house prices in the UK had started to fall. There are many short term factors which are bringing house prices down.

• Sharp fall in mortgage lending. The credit crisis means the banks are struggling to raise money to finance new mortgages. Because there is a shortage of finance they are cutting back on the number of mortgages. The number of mortgage approvals fell by 40% on last year.
• Rising unaffordability. The cut back in mortgage lending has coinicided with a period of declining affordability. The ratio of house prices to incomes is over 5 for first time buyers. This means that most cannot borrow enough (unless they can get a hefty deposit from their parents)
• Interest rates not falling. Bank is cautious about reducing interest rates because of rising inflation. When the bank does cut base rates, commercial banks are often not passing them onto consumers.

Yet, despite the prospect of short term house price falls, what are the prospects in the long term?

• Firstly, house prices don't always recover from property crashes. The property crash in Japan in the late 80s was very prolonged.
• After the last house price crash in 1992, UK house prices did recover after a couple of years. Firstly slowly but then very rapidly.
• In the US, the prospects for future house prices look grim. There is a higher level of mortgage defaults and the falling demand has coincided with rising supply; leading to record levels of unsold properties. People even joke of knocking down unsold houses in America.
  

Long Term House prices forecasts in the UK.

When the mortgage industry gets over its current difficulties (and prospects look bad in the short term - it is hard to see when the difficulties will end) there is good reason to suggest that house price will remain high and over time could regain their upward movement.

These are some reasons why house prices in the long run may continue to rise - Long Run Forecast for UK Housing Market


Are Rising House Prices A Good Thing?

Just because I predict house prices may rise, doesn't mean I think that is a good thing. Personally, I would like to see the government take steps to increase the housing supply in the long term. I think that house prices are too expensive, and this is causing great inequality within UK society. The ideal solution would be for several years of stagnating prices, enabling incomes to catch up with prices. Definitely, the government should try and take steps to avoid boom and bust in the housing market, but, there is no guarantee they will be able (or willing to do this)

Recently, much of the focus has been on the prospects of the US entering into recession. However, the EU and Eurozone in particular look susceptible to the prospects of a recession.

The effects of the credit crunch are being increasing felt in Europe. However, unlike the US, the Eurozone faces additional difficulties to the economy, not confined to just the credit crunch.

• Strength of the Euro. The marked appreciation in the Euro is presenting exporters with both rising costs (from oil prices) but also declining competitiveness. Economies such as Germany are particularly reliant on exports, and the strength of the Euro is now harming the manufacturing sector.
• Attitude of ECB. The ECB has a strong inflationary stance. This means it is reluctant to cut rates and boost the economy. The ECB seems more concerned about the increase in inflation (due to cost push inflation) than it does about the prospects of a downturn in the economy. This contrasts with the US who have cut rates aggressively.
• Housing Boom and Bust in EU The US is currently experiencing a housing crash, but the EU could also be facing a recession in the housing sector. For example, Spain's housing market looks precarious with houses overvalued. A slump in prices would hit the construction sector, a key element of the Spanish economy.
• WPP, the world's largest advertising group said advertising revenue for Europe had fallen markedly in the first months of this year (unlike US where revenues had stayed constant) [1]
  

The UK economy is currently growing at about 2.5% a year however, this reflects past economic trends, rather than current and future economic conditions

Whilst the West worries over rising petrol prices and the scarcity of mortgages, the developing world faces a threat to the most basic necessity of life - enough food to eat.

After decades of abundant food supplies, recent years have seen a marked increase in the price of food. In the west, this just about reaches our attention as we note the price of bread passes £1. But, for those living on $1 - $2 a day or less, the increased food prices can be devastating, leaving many below the poverty line.

Why Food Prices Have Increased?

Increasing Demand has come from:

1. Economic growth in China and India. Increased living standards mean people are consuming more food and also more land intensive foods. For example, as incomes rise people buy more meat. Meat is more land intensive, because you need both land for the livestock and also crops to feed the livestock.
2. Growing Population. -The world's population is currently 6.5 billion this is forecast to grow up to 9 billion in a couple of decades.
3. Demand for Biofuels. As the west look for alternatives to oil, governments are encouraging the use of biofuels which are supposed to provide an 'environmentally friendly' alternative to oil. However, the increased demand is pushing up prices.

Problems with Supply.

1. Environmental problems. Global warming is contributing to desertification of former arable areas. Therefore, some countries are experiencing declines in available agricultural areas. In western countries, it has proved difficult to increase productivity of arable land. Increased use of fertilisers e.t.c has reached a point of diminishing returns.
2. Inelastic Supply. Another problem related to agriculture is the time lags involved in growing crops. Most crops can only be grown once a year. It can take even longer to prepare land for more crops. Therefore, the high prices have not been able to encourage more supply; eventually the high prices may encourage more supply, but, by then it may be too late contributing to the volatility of food prices.
3. Restrictions facing Local Farmers. In many developing countries agriculture is characterised by small scale farmers, who lack the ability to invest in new technology and enable more efficient farming. Basically, despite the rise in prices, there is little that many farmers can do to increase supply.

How To Deal with the Food Shortages?

To deal with food shortages is not straightforward. There are many issues to consider.

In the short term aid is necessary to deal with chronic shortages. But, at the same time, food aid needs to be carefully managed to avoid hurting local farmers. Aid will at best provide short term relief. A long term solution is to investigate ways to boost the productivity of agriculture, especially in developing countries where poverty is at its highest.

The Euro is a bold experiment to create the largest curreny area in the World. The Eurozone is a diverse area and whether it is an optimal currency area is a matter of debate.

The Euro involves:

1. A single currency within the Eurozone area.
2. A Common Monetary Policy. Interest Rates are set by the ECB for the whole Eurozone area.
3. Growth and stability Pact. Limits on government borrowing, national debt and fiscal policy. However, in practice member countries have often violated the strict limits on government borrowing.

Problems of the Euro.

• A common monetary policy involves a common interest rate for the whole eurozone area. However, the interest rate set by the ECB may be inappropriate for regions which are growing much faster or much slower than the Eurozone average. For example, if the French economy was in a recession, it would benefit from lower interest rates to boost demand. However, France no longer has the flexibility to be able to cut rates. Therefore, it could be stuck in a recession and not able to cut rates.
• Not an Optimal Currency Area. If a state in the US like New York was in recession, it is argued that people in New York could move to New England and get a job. However, in the Eurozone this is much more difficult; it involves moving country and possibly learning a new language. There are more barriers to the movement of labour and capital within a diverse region like Europe.
• Limits Fiscal Policy. With a common monetary policy it is important to have similar levels of national debt, otherwise countries may struggle to attract enough buyers of national debt. This is a growing problem for many Mediterranean countries like Italy, Greece and Spain who have large national debts. For example Italy's national debt is over 100% of GDP.
• Insulation against Currency Crisis. It is argued that being a member of the Euro protects a country from a currency crisis. Therefore, there is less incentive for countries to implement structural reform and fiscal responsibility. This is even more important given the fact that devaluation is not an option.
• No Scope for Devaluation. Euro countries are locked into the fortunes of the Euro. The Euro has been appreciating sharply in recent months because it has become an alternative to the dollar. If the Euro became the World's reserve currency its value could appreciate even more. However, the strength of the Euro is creating problems for European exporters and the European tourist industry. The appreciation in the Euro could start to harm prospects for economic growth in the Euro Zone. The main problem is that there is no flexibility for depreciating. This is also a problem for countries with large current account deficit. Traditionally, devaluation is a solution to current account deficit because it makes exports cheaper, but European countries have lost this as a possibility.

Problems for UK Economy.

UK economy has additional problems which make joining the Euro a bad idea.

• Housing market. Many in the UK have a mortgage which is a big % of their disposable income. This is related to the high cost of buying houses in the UK.
• Variable Mortgages In the UK more homeowners have variable mortgages. These two factors means UK consumers are very sensitive to changes in the base rate. If the ECB kept interest rates higher than the UK needed it would create serious problems in the UK. Arguably to join the UK would need to reform its housing market and reliance on variable mortgages.

Related Posts on the Euro

• Benefits of Joining the Euro
• Costs of Joining the Euro
• Predictions for the Euro
• Danger Ahead for Mighty Euro at Economist
  

A reader asked a question about official inflation statistics. Basically, he articulated a widely held belief that the Government's official method of inflation failed to report the true level of inflation in the UK. There are a number of explanations why people may feel 'actual inflation' is much higher than 'official inflation'. Some of this represents the way inflation is calculated. Other reasons reflect the psychology of people giving more weight to bad news rather than good news on inflation. See: The Real Rate of Inflation in the UK

Unemployment Statistics.

In the UK, there is also a discrepancy amongst different calculations of unemployment. In recent years the government have made it more difficult to claim unemployment benefits, so the official 'claimant count method suggests much lower unemployment than other measures. However, there are also additional problems with measuring unemployment. In particular there is an issue of disguised unemployment - people doing short term / temporary work. See: True level of unemployment

In this essay on France vs UK Economy. I came across a study which noted that although French unemployment was higher than US unemployment; the % of the Labour force in employment was the same. This highlights the difficulty of comparing economic statistics between different countries. It also feels that there are so many different ways to use statistics that you can more or less find some statistic to make up your beliefs. Therefore, when dealing with economic statistics we should always be wary and understand why they may be inaccurate.

Today the Bank of England unveiled a package to inject up to £50 billion into the banking sector. [Independent link] Their scheme allows banks to exchange unpopular mortgage securities for trusted government securities. In theory it is hoped this will enable the banking sector to find it easier to raise money and reduce the cost of interbank lending. It is hoped this will reduce the cost of mortgages and make more mortgage products available for first time buyers.

Why is the Tax Payer Bailing out the Banking Sector?

Since the subprime crisis in the US, it has become very difficult for banks to raise finance for mortgages. This has led to many mortgage products being withdrawn and the cost of mortgages going up. This has caused a fall in mortgage lending and has precipitated a shorp fall in house prices. It is feared that falling house prices will reduce consumer spending and lead to recession.

It is hoped that the scheme will enable the money markets to 'unfreeze' leading to lower mortgage rates, especially for first time buyers. It is also hoped that the scheme will not actually cost the taxpayer anymoney. The Bank of England is not giving money but offering to exchange the type of securities that banks hold at a commercial rate.

Is The Bailout a Good Deal for Tax Payers?

Mortgage debt is currently riskier than government debt and in theory taxpayers money is at risk. However, the Bank of England argue banks will be paying commercial rates because they will have to offer more 'risky' mortgage securities in exchange for 'safe' government bonds.

The taxpayer could lose out if mortgage defaults rise excessively and a bank defaulted on its payments and the securities it offered proved inadequate. This is unlikley to occur with base interest rates more likely to fall rather than rise. (However, nothing is impossible given recent events)

If the scheme is successful and softens the housing crash and softens the slowdown in growth, the taxpayer could benefit from avoiding a recession and the corresponding decline in tax revenues.

Is it Not Better Just to Let the Housing Market Crash and Allow House prices to return to Normal Levels?

Many argue that since house prices are overvalued, this scheme merely delays the inevitable. Therefore, it is better to get the pain with over quickly and not intervene.

However, if house prices are overvalued there are benefits to encouraging a slow and gradual readjustment rather than rapid shock which could precipitate a recession. Also the mortgage markets have gone from one extreme to another. 12 months ago, the market was very competitive and overly keen to lend. Recently banks have become excessively cautious, causing lending to become much stricter and tighter than necessary. This scheme will hopefully help restore a little confidence to interbank lending and enable a less extreme readjustment.

Will The Bailout work?

The markets were rather cautious about the scheme's capacity to stop the slump in falling house prices.

There is no guarantee banks will use the extra finance to reduce mortgage rates for consumers. (The Bank admit they are powerless to tell the commercial banks how to use this extra finance). Some argue the extra funds are not particularly attractive, because commercial banks need to give a premium to attract sufficient funds.

If necessary the Bank hinted they could free up to £100 billion.

See also: Overvalued Housing Market

Bank details £50 billion lending boost

• Rogue Economics at Amazon.com
• Rogue Economics at Amazon.co.uk

I became interested in Rogue Economics by Loretta Napoleoni when researching an article on obesity. She covered the issue in just a couple of pages but it provided some key statistics and interesting ideas on the causes of obesity.

The thing I like about the book is that it covers many of the new economic issues not covered in textbooks. She deals extensively with the economic impact of the internet, new technologies and the rise of China's economy.

The chapters on China are interesting in explaining how the Chinese economy is based partly on a fanatical work effort which has its base in the ideology of Mao.

Another feature of the book is its ability to debunk widely held beliefs. This doesn't just include myths held by Chinese people, but also explaining the new source of power and influence and why there are so many Russian Oligarchs living in suburbs of London like Chelsea.

It is not dogmatic or highly ideological, but tries to understand the essence of economic problems. For example, in society there is a tendency to label 'globalisation' as good or bad. However, this simplistic understanding fails to account for the intricacies of individual issues.

There is a good chapter on the recent credit crisis. For example, by 2006, US mortgage lending had reached $7trillion or 10% of the world's economy. American debt (40% of these mortgages required no downpayment. The big losers of this crisis are likely to be middle class couples with children.

Yet, for every problem there are also some who win. In this case it is those companies specialising in dealing with bankruptcies and credit collection. This is a theme of the book, highlighting those who have benefited from the new economy. The winners don't particularly make for encouraging reading. Those who are benefiting from the modern economy include: internet gambling and prostitution sites, Russian Oligarchy, and debt collection agencies. It provides little comfort for the average worker, but, it is an interesting take on Economics.

Buy Rogue Economics at Amazon

• Rogue Economics at Amazon.com
• Rogue Economics at Amazon.co.uk

Other Economics Links

• A readers asks about the Bank of England's plan to inject money into money markets
• Worldwide Obesity Rates
• Why Increased interest rates effects the housing market more than the stock market

In the United States, obesity has overtaken tobacco as the biggest killer of people. 16% of all deaths in the US (400,000 a year) are attributed to obesity. [1]

• From the late 1970s to 2000s the incidence of obesity rose from 12% to 25%.
• Diseases such as diabetes have increased markedly in this period - from 5 million to 20 million.

Given that obesity is such a problem and imposes significant costs on people's health and the economy, it is perhaps surprising that more has not been done to solve the issue. But, it is worth bearing in mind that a lot of companies are making high profits from obesity. Firstly farmers are selling more crops, food companies are selling more food and health companies are receiving large payouts for dealing with the consequences of obesity. The health spending of course does not tackle the fundamental problem of obesity; it merely tries to massage the effects.

Why Has Obesity Risen?

1. Increased Consumption of Sugar / Carbohydrates

In recent decades there has been increased production of Corn syrup. Helped by government subsidies, the production of high fructose corn syrup has led to falling prices of simple carbohydrates. Basically, high calorie, high carbohydrate food has become cheaper encouraging people to consume more high calorie foods. Fruits and vegetables on the other hand have become relatively more expensive. There is an economic incentive to buy foods that are unhealthy and lead to obesity. This is why obesity is often worst in low income groups. The poor can afford food, but, they struggle to afford healthy food - buying instead cheap carbohydrates and take away McDonalds.

2. More sedentary lifestyles. With an increase in car use, there has been a corresponding declining in physical exercise such as walking to shops. [2]

3. Bigger Sizes. It is argued the 'super size' food portions encourage people to eat more. This is controversial, the argument against is that in the past, people would simply have bought two 'small' sizes to get one big size. However, I don't believe this. When I go to America, you get bigger portions so I eat more, when I return to England, I don't order 2 medium sized portions just so that I can get an American sized portions. We can't just blame food companies, clearly there is a demand for 'super size' foods otherwise people wouldn't order them.

The Genetic Myth.

Many argue the cause of obesity is genetic. But, if the cause of obesity is genetic why has it not been a problem until the last half of the twentieth century? The answer is that genes can make certain groups of people more susceptible to putting on weight and becoming obese. But, genes can never be the only cause of obesity; they merely make it more likely to occur for some people. Certainly the rise in obesity cannot be explained by a rapid change in the gene pool.

The Fat Myth

Ironically, America's booming obesity has been related to its growing obsession with fat intake. Low fat foods are very popular; but it appears reducing fat intake does not solve the problem of obesity, if lower fat is replaced with higher carbohydrates. Also many low fat foods are only marginally less fatty than their original sizes. The % of fat in American diets has fallen from 40% to 34% yet obesity has risen.

Solutions to Obesity

1. Do Nothing. It is not unreasonable to say obesity is not the government's problem. If people choose to eat a lot of food and lead sedentary lives it is their choice - and who is the 'nanny state' to tell people how to live?

• However, the problem is that from an economic perspective obesity imposes tremendous costs of society. Costs of obesity include:

• Health costs of treatment
• Lost hours at work due to health related disease.
• Death. 400,000 deaths a year is a sobering statistics. Consider how much the government will spend on fighting terrorism which accounts for a fraction of the annual number of deaths. If your only target was to save lives, you would immediately switch resources from security measures to fighting obesity.

2. Tax Unhealthy Foods.

If high corn syrup foods cause obesity and therefore externalities to the rest of society, then it make sense to tax it. (or at the very least stop subsidies for growing high carbohyrdate foods. See: Why we should tax Unhealthy Foods.

3. Get People Out of Cars.

50% of car journeys are less than 2 miles. People have become reluctant to do any exercise and always prefer to take motorised transport. You could reduce dependence on cars by increasing taxes on petrol and raising the legal driving age. Neither would be popular; but, it would be effective in dealing with obesity. (see: Rising petrol prices reduce obesity) see: Call to ban car use to schools)

4. Legislation about Food Content and Food Sizes.

This would be rather controversial as it involves heavy government regulation on people's diet. But, limiting food sizes could be a solution.

Statistics for Obesity came from:

1) Loretta Napoleon Rogue Economics Chapter six, citing interview with Dr James Kenney

[2] International journal of obesity

Readers Question: Does France Provide a Better Economic Model than the UK?

French / British Rivalry extends far back in time to the devastating 100 years war. These days national rivalries are mostly played through sport or Economic development. This essay takes a short look at whether the French economy is doing better than the UK.

Problems of French economy

Economic Growth 2001-2006. In the period 2001 -06, the UK economic performance generally exceeded its European counterparts. The French economy and Eurozone experienced sluggish growth as it struggled with a Common monetary policy and inflexibilities in the labour market. see: UK economy outshines its peers Source: BBC (note: the forecasts in this data were overly optimistic for the Eurozone)

Graph of French Economic Decline Compared to UK and US


Unemployment. Furthermore, it is argued that the UK benefits from lower levels of unemployment compared to our European counterparts, especially France and Spain.
For example, in 2007, ILO unemployment in the UK is 5.4%, in France, 8% Source
Anecdotal evidence suggests upto 50% of young people are unemployed, contributing to the riots of 2005.

Source: French flee stagnant economy at MSNBC

Labour Market Inflexibilities. It is argued a weakness of the French economy is rigidities in the labour market. Critics (such as the Economist) regularly point to inflexibilities such as a maximum working week of 35 hours and the difficulty of hiring and firing workers. It is argued that these restrictions deter investment and productivity growth. Also trades unions in France are more powerful and arguably have created labour market unrest, preventing necessary reforms.

Problems of Being In Euro. Being in the Euro means that countries like France cannot devalue the exchange rate to boost exports. The rise of the Euro in recent months is making French exports relatively less competitive and this could weaken French growth. Also the common monetary policy means that interest rates may be unsuitable for the French economy. The UK has greater flexibility to cut rates if the economic situation requires it. Recently, the Pound has weakened against the Euro providing a boost to the exporting sector, helping to offset the fall in consumer spending.

However, it is argued that the French economy is not as sickly as it is made out to be.

Strengths of French Economy

• Growth is picking up, although it is still struggling to reach 2% per year. Forecasts suggest growth will remain below trend for quite a few years to come.
  
• Unemployment statistics suggest unemployment in France is higher, but labour market participation ratios of 87% are the same as in the US. This suggests that unemployment figures may be misleading and not as bad in France as some claim.
  
• French labour laws provide security and protection for workers. In the UK and US it is argued there are more part time / temporary/ low paid jobs.
• There is lower child poverty in France (see Le Monde article)
  
• Le Monde makes a strong case for the French economy - see: english translation

The French and UK Housing Market.

Arguably, the UK's housing market has been a key factor in generating higher levels of consumer spending and economic growth. As house prices in the UK start to fall, it will have a powerful effect on reducing consumer spending and lowering levels of economic growth. Furthermore, it is argued UK house prices are overvalued and could fall by upto 25%. This means that the strong UK economic performance of the past few years may start to unravel as a slumping housing market causes lower growth.

In France, the housing market is less important to the economy. The ratio of homeownership is lower; it is about 50% rather than 77% in the UK. The French economy is not quite as unbalanced. The UK economy is susceptible to a fall in house prices and it could lead to a recession like the last time house prices fell in 1992. France will be less affected by the subprime crisis, even if French house prices are still overvalued by up to 20%

Overvalued housing markets in France and UK

References

• French Economic Statistics at Economist
• Predictions for French economy

Readers Question: Why Does an Increase in the Minimum Wage not Cause Unemployment?

Classical Economic theory predicts that an increase in the Minimum wage should lead to unemployment. If the minimum wage(Wtu) is placed above the equilibrium We, demand for labour falls creating unemployment of Q2 - Q1


In a survey amongst economists by Dan Fuller (2003), he found 46% of Economists agreed with the statement that “minimum wages cause unemployment amongst unskilled workers” only 24% disagreed with this statement. [1]

However, the experience of the UK is that increasing the minimum wage has been compatible with falling unemployment and rising levels of employment.

• The minimum wage was introduced in the UK in 1999 at £3.30.
  
• As of October 2007 the minimum wage for adult workers is £5.52. (It will rise to £5.73 by end of 2008)
• There is a development rate for workers 18-21 of £4.60
• For people under 18 (not of compulsory school age) the rate is £3.40
• Source: National Minimum wage HMRC - [2]

In 1999, UK unemployment was 1,822,000 between January and March.(ILO method)
by 2008, UK unemployment has fallen to 1.61 million or 5.25%. Employment rates have also increased to 74%. The claimant count method is even lower at only 793,000 UK Unemployment stats

The experience of the UK is that a 67% increase in the NMW has reduced unemployment and increased employment. The UK is not isolated, in the US, studies have also show a link between increasing the NMW wage and negligible effects on employment. E.g. David Card and Alan Krueger, in their 1997 book Myth and Measurement: The New Economics of the Minimum Wage

Reasons Why Higher Minimum Wage has Led to Increased Employment

1. Strong Economic Growth. In period of economic growth, firms employ more workers as there is more demand to produce goods. Economic growth in the UK has averaged 2.5% since 1999

2. Monoposony Power. Classical theory assumes labour markets are competitive, but, in practice workers often face employers with buying power. This means firms are able to pay workers less than the market wage. Therefore, when a government artificially raises wages, firms can actually afford to pay them. It is argued minimum wage legislation is similar to anti trust regulation. [see: Monopsony and Minimum wages]

3. Increased Productivity. A study by David Metcalf [3] found that firms responded to increased wages by increasing the productivity of workers, especially in the service sector. This is important because it suggests that higher wages can actually help increase productivity in the economy.

4. Lower hours. Rather than make workers redundant, firms have reduced the average hours worked. This is related to part 3, firms try to get higher productivity in a shorter time, so they can afford the minimum wage.

5. Pass on Cost increases. Because the minimum wage affects all firms, it is easier for the cost increases to be passed onto consumers. e.g. because all cleaning firms have higher wage costs, they can all increase their prices. If the wage increase just affected one firm, they would become uncompetitive. (note: the rise in prices has not led to significant inflation in the UK)

6. Avoidance of Minimum Wage. It is uncertain to ascertain the extent of this problem, but some firms have circumvented the minimum wage legislation by employing immigrant labour and paying them lower wages. It also makes it more attractive to employ young workers.

Related Essays

• Does A Minimum wage reduce unemployment?
• Disadvantages of Minimum Wages

In the past 12 months, US house prices have fallen by nearly 15%. This reflects a correction to a period of rapidly rising house prices, fuelled by cheap lending. However, the concern over house prices is not limited to the US. In fact, a study by the IMF suggests that many other countries have house prices that are overvalued relative to earnings, rent prices and other long term house price trends.

According to the IMF, house prices are most overvalued in Ireland (30%), Netherlands and Britain (29%) America by contrast have house prices overvalued by only 10%. Therefore, there is a real possibility of housing slumps in other countries; if these housing slumps occur it could trigger slowdown in global growth, especially in Europe and OECD economies.

Graph of House Price Overvaluation


Source: Economist

Why House Prices are Overvalued.

Era of Cheap Borrowing. In the past 10 years, lenders have been keen to extend mortgages to consumers who were previously thought to be high risk. Examples, include subprime mortgages and lending upto 5 times incomes. The competitive mortgage industry made mortgages cheaper than usual and encouraged more groups of households to take out mortgages. However, the subprime crisis has dramatically altered the mortgage industry. The number of mortgage products has substantially fallen, making it much more difficult to get a mortgage unless you have a large deposit. (see: credit crisis 2008)

Supply Constraints in Many Countries. The supply of housing is notoriously inelastic in many western economies. There is a shortage of land and a difficulty of gaining planning permits; this means housing supply struggles to meet with growing demand. However, the supply constraints do not explain all the house price increases.

Speculation. The era of rising house prices encouraged people to 'buy to let'. Landlords bought houses to gain income from both rent and capital gains. For example, in the UK, the proportion of mortgages held by landlords has risen from 1% to 10%. It may be that as the market turns this new group of homeowners will be much keener to sell.

Ratio of Earnings to House prices. The ratio of House prices to earnings shows that house prices have increased above long term trends and makes house prices susceptible to a substantial fall to correct the lack of affordability. This is particularly notable amongst first time buyers who are struggling to get on the property ladder.

Graph of House Price to Earning

Is the End Nigh? - Why the Housing Crash may be less Severe Than Feared

Despite the grim prognosis of many analysts, the UK and other European economies may still be able to avoid a slump in housing prices similar to the US. These are some factors which may prevent a housing slump as bad as the US.

1. Ratio of Mortgage payments to Earnings is below historical highs. Long term Interest rates are lower than in the early 1990s and this has made the cost of paying for a mortgage relatively cheaper.
2. Prospect of Lower Interest rates. If house prices do fall and western economies slow down this will lead to lower inflation and therefore, there can be cuts in interest rates. This will make buying a house seem more attractive. It is also worth noting UK interest rates are much lower than the last time we had a housing slump. However, there are 2 complications

• Credit crisis is causing bank interest rates to be more expensive. Therefore, base rate cuts may not lead to cheaper mortgages
• Cost push inflation due to rising oil and food prices makes interest rates cuts more difficult.

1. Negative Equity will be concentrated on a small % of the housing market. Because UK house prices have risen by 217%, even a 15% fall in house prices would leave most people with positive equity. Experian, a credit-scoring firm, reckons that if house prices fell by 20%, only 78,000 households would have mortgages worth more than their homes [ source]
2. Supply constraints are more serious in Europe, UK than in America
3. The American housing bust was related to a large oversupply in houses. The housing boom caused a big rise in the supply of housing and this was a key factor in pushing US house prices down. In the UK, housing shortages are still a problem
4. America had the highest % of risky, unaffordable mortgages. The American mortgage industry was the least regulated, offering subprime mortgages to people who had a high chance of defaulting on their mortgage. Generally, european mortgage industries were better regulated. At the moment, defaults in the UK are not at a critical level and are unlikely to get worse.
5. Move to Longer Term mortgages and borrowing from parents. As people move to longer term mortgages and borrow from parents for a deposit, it facilitates a rise in house price to earnings ratio in the long term. This does not necessarily mean it justifies the rise from 2.5% to 5% we have seen. But, there is no law the long term house price to earnings ratio has to remain the same.

Conclusion

The unprecedented rise in house prices do have some fundamental economic reasons behind them. Nevertheless there is also clear evidence that, at least part of the rise, is due to speculative buying, and this creates the potential for significant house price falls as the market turns. The extent of the house price slump may not be as severe as the worst predictions. (I don't think the European markets are precarious as the US, but, there were many who said US house prices would never fall. Also if conditions in the credit markets continue to worsen it will further worsen the prospects for house prices.

• Boom and Bust in US housing Market
• Problems in UK Housing Market
  
• Why House Prices are set to Fall
• Fears over House Prices
  

Readers Question: Is there an economic term for the phenomenon of ignoring (or turning a blind eye to) future risk, assuming that the current situation will prevail? I refer to the situation we currently see of both borrowers and lenders who are being caught by interest rate rises, having seemingly assumed that interest rates would stay low.


An assumption of classical economics is that consumers and firms are rational. i.e. they take care to make the best choices given the information available.

In theory, people would seek to avoid situations where they buy overvalued assets. However, in the real world, we often seen asset bubbles and behaviour which seems to be irrational. This is often termed irrational exuberance. It is studied in behavioral economics

Examples of Booms and Busts

Throughout history there have been many examples of speculative booms where investors jumped onto rising commodity prices, ignoring the economic fundamentals. Some examples of famous booms and busts include:

• The price of tulips 17th Century immortalized by the book "Extraordinary Popular Delusions and the Madness of Crowds, "
• The South Sea Company 1720
• Florida Real Estate craze of 1926
• The Wall Street boom of the 1920s and crash of 1929.
• Dot Com bubble 2000-2002
• House price boom in America 2001-2007

In all these cases, people ignore potential risk and get caught up in a wave of speculative buying. Assets tend to rise by much more than there underlying value. However, there comes a point when people realise the assets are overvalued and so start selling. This can cause an asset slump. The bubble can turn to a bust. After the bubble has burst, people start asking the question - why did so many people ignore the risk and get carried away?

Why People ignore Risk

• The Madness of Crowds - This is the idea that the majority must be right. If other people are piling into a stock, it must be a good thing. Therefore, people feel safe because the so called experts are recommending the stock. This is sometimes known as the herding effect.
• New Paradigm. This applied particularly to the dot com bubble in 2000-02. People were aware share prices were worth much more than earnings suggested they should be. However, the argument was that internet stocks were different to old stocks. The internet offered a chance for speculative growth, therefore, we shouldn't use old pricing formula's.
• People like the prospect of making a lot of Money. These asset bubbles generate stories of people making a lot of money. Maybe people think they can beat the market. i.e. they know there could be a crash, but, they believe they will be able to get out at the top.

Situation at the Moment.

In the post 2001 period there was a period of easy and cheap credit. People felt that low cost borrowing would continue for a long time. Therefore, many took out risky mortgages. Mortgage companies sold on their debt, thinking this acted as a kind of insurance. The problem was that the risk of lending was spread throughout the financial sector. People taking out mortgages felt secure because:

• The mortgage companies who were very keen to lend.
• Interest rates were very low (especially in the US)
• Mortgage companies were keen to lend because they saw house prices rising (and felt they would always keep rising)
• They sold on their loans in the form of CDOs to other finance companies.

However, the problem was that, interest rates of 1.5% didn't last. They increased as consumer spending rose. Mortgage companies in the US, were motivated to sell mortgages that were inappropriate.House prices didn't keep rising.

The effect was that mortgage defaults rose and house prices fell. This led to the credit crunch and shortgage of funds causing interbank lending to become more difficult and expensive.

The problem here is that people were focused on a small aspect of the overall picture. There was certainly a strong sense of belief in rising house prices. Also the last financial crisis, led the Federal Reserve to aggressively cut rates to avoid problems.

However, it is of course, always easy to be wise after the event.

Related:

• Problem with bailing out financial sector
• Credit Crunch 2008
• Economic Booms
• Economics of the Stock Market
  

I recently wrote an article about Inflation in Zimbabwe, which has recently passed the 100,000% causing widespread hardship for the population.

Definition of Hyperinflation: A rapid and unchecked increase in the price level. Typically it may involve inflation rates of greater than 100% or greater than 1000% Hyperinflation is often reported per month, or even per day. Another distinguishing feature of hyperinflation is the idea that inflation is out of control. i.e. not only are prices rising rapidly, but the rate of increase is rising rapidly as well. With each cycle inflation gets worse.

Examples of Hyperinflation

— The most severe month of hyperinflation occurred in Hungary in July 1946 when prices increased by 4.19 quintillion per cent (4,190,000,000,000,000,000 %)

— In the same year the Hungarian National Bank issued a 10 quintillion pengo note (one followed by 19 zeros 10,000,000,000,000,000,000)

— During the hyperinflation episode in Germany from 1922 to 1923, the Weimar Republic printed postage stamps with a face value of one billion marks, as prices doubled every two days. At one point in 1923, the exchange rate equalled one trillion Marks to one dollar

— In Yugoslavia prices increased by 5 quadrillion per cent between October 1, 1993, and January 24, 1995

What Causes Hyper Inflation

Usually, countries with hyper inflation have the following features

• Large government debt, usually over 100% of GDP
• Printing Money. To cope with meeting the debt, the government starts printing money. This decreases the value of existing money creating a multiplier effect where people lose confidence in money and keep demanding wage increases.
• Reluctance / inability to deal with it. When Germany experienced hyperinflation in the 1920s it was not a phenomena they fully appreciated or understood. Their primary fear at the time was unemployment. They feared that unemployment could precipitate a Communist Revolution so they didn't want to do anything to reduce demand and possibly cause a recession.

Economic Costs of Hyper Inflation

1. Value of Savings falls. In a modern economy, interest rates are usually higher than the inflation rate. For example, if inflation is 5%. Interest rates may be 7%. Therefore, if you keep money in the bank or insurance fund, you maintain the real value of your money. However, when inflation becomes excessive, the rate of inflation is usually much higher than any potential interest rate. Therefore, people with savings see the real value of their wealth wiped out.

• There is the story of people in Germany who began a saving scheme in 1903. For 20 years they put 10% of their wages into a pension scheme. When they cashed they pension scheme in 1923, it gave them enough money to buy a cup of coffee.

2. Menu Costs. These are the costs of dealing with rapidly rising inflation.

• A consumer noted that the price of coffee was 5,000 Marks. He ordered one cup of coffee and when he finished drinking that coffee, he ordered another one. When the final bill came to 14,000 Marks he was told that the price of coffee and increased during the time he was drinking the first one.
• When people got paid at 10am in the morning, they would have to spend it straight away, otherwise the wage would become worthless. There is the story that to pay teachers, the money had to be carried in a lorry. When the lorry came and distributed the wheelbarrows of money, the teachers gave it to relatives who would go off and buy goods straight away.

3. Lack of Confidence in the Finance Sector

The experience of inflation can become engraved on people's mind making them suspicious of financers, bankers and the general economic system. It is no coincidence the Nazi party were able to feed off these suspicions to introduce extremist policies.

4. Lack of Investment and Economic Growth

Ultimately hyperinflation causes people to have lower spending and firms lose confidence in investing. This can cause the economy to slow down and reduce living standards.

• Causes of Inflation
• Costs of Inflation
• Essay on German Hyperinflation of 1923

Governments hold foreign currency reserves to help deal with issues such as a depreciation in their currency. At the moment, the world’s biggest foreign currency reserve is the US dollar; about 64% of the World’s foreign currency reseves is currently denominated in dollars. This is because, historically, the US economy has been the most secure and powerful economy. However, with the continual decline in the dollar, many countries are fearing that the dollar is no longer the best currency to use and increasingly countries are switching to other currencies such as the Euro.

Pricing of Commodities in Dollars.

A separate, but related issue, is that most commodities, e.g. oil prices, are also priced in dollars. Oil prices are denominated in dollars because currently the dollar is the most common currency. If the dollar was to be replaced by the Euro as the world’s currency reserve; it is more than likely that we would see commodities priced in Euro’s. In fact, some countries are already starting to use the Euro rather than the dollar

Will the Euro Replace the Dollar as the World’s Reserve Currency?

• Since 1999, the Dollar’s share of the world’s currency reserves have fallen from 70.9% to 64%
• In the same period, the Euro has increased from 17.9% to 25.8%
• (the 3rd biggest reserve currency is the Pound sterling 4%
• (the 4th biggest reserve currency is the Japanese Yen 2.8%)

Why the Euro May soon Replace the Dollar

• The Dollar has been very weak in the past 8 years. Against the Euro, the Dollar has fallen by over 30% since 2001. The Dollar has also fallen against the Yen and other currencies. This means that countries holding reserves in dollars are seeing a decline in their value. For example, China has over $1,400 billion of dollar reserves. A 20% devaluation represents a significant loss for them. Therefore, the rational step is to diversify out of the dollar.
• Countries dropping the Dollar Peg. Many middle eastern Countries such as Saudi Arabia, Kuwait and Syria used to maintain a dollar peg. However, there are signs that they no longer want to keep a peg against a devaluing dollar. Kuwait and Syria have dropped their peg and Saudi Arabia recently decided not to follow the US in cutting interest rates.
• Dollar’s weakness may continue. The US economy is continuing to slowdown as it remains hard hit by the housing slump. US interest rates have fallen and may continue to fall by more than the Eurozone. As interest rates in the US are low it becomes less attractive to buy US dollars so the devaluation will continue.
• US Trade Deficit (current account deficit of 5%). In recent years, the US have built up a large current account deficit. This has caused an outflow of currency and is a factor in maintaining the weakness of the dollar. (although the recent devaluation though has helped reduce the deficit from over 6% to 4.7%)
• The Euro is a real Alternative. The Euro economy is now as large as the US. The Euro may also be seen as more politically desirable. European countries were less willing to get involved in Iraq and many accuse the US of an ‘imperial overreach’ with too many foreign bases and interference around the world. The European Union by contrast provides greater diversity and is politically more attractive, especially to middle eastern countries.
  
• Better inflation performance of the Eurozone to US. There was a marked contrast in response to the recent credit crisis. The US slashed rates to 2.25%, the ECB barely cut rates at all. The lower rates and devaluation of the dollar makes future inflation in the US more likely, this will only make the US less attractive.

Changing the world’s reserve currency is something that doesn’t happen very often. The US have enjoyed a hegemony really since the end of the first world War. However, that is no reason to suggest that the dollar’s influence will continue. Sooner or later, economic fundamentals are likely to cause people to shift out of the dollar and into alternatives. I will look at the consequences of this potential change in future essays.

• Euro to Dollar Exchange Rate Forecast
• Reasons for the fall in the US Dollar
• Effects of a falling dollar
• Will the Euro Replace the Dollar at Economist's view
• Why the Euro will soon replace the dollar as the world's reserve currency
  

The Economic Naturalist - Why Economics explains almost everything by Robert H. Frank

The Economic naturalist is another book in the genre of what might be called 'popular economics'. Although this formula of applied Economics has been used many times before, I feel this offers a useful addition to the growing genre of applied economics.

It is based on questions asked by first year students of Robert Frank's economic course.

The thing I like about the book is the quantity and diversity of questions and corresponding answers. There is little in the way of complex terminology, most answers rely on simple concepts such as opportunity cost and cost benefit principles. The answers are also quite short and to the point. On some occasions it leaves you thinking that there are many other possibilities as well. But, the important thing is that it generates a wealth of thought provoking ideas related to economics principles; the questions and answers would be just as interesting to non economists as economists.

Examples from the Economic Naturalist

• Why Do Animal Rights activists Target fur-wearing women but leave leather clad bikers well alone?

Some answers suggested:

1. The physical and evolutionary advantages of harassing old women versus burly bikers.
2. The total number of animals it takes to make a fur coast versus a leather jacket. "Perhaps animal activists feel, in a finite world with limited time and resources, they should strategically target the activities that abuse the most animals."
3. The cost benefit analysis of gaining converts to their cause as opposed to the cost of alienating people.

Some of the questions themselves are intriguing:

1. If attractive people are more intelligent than others, and if blondes are considered more attractive, why are there so many jokes about dumb blondes?
2. Why is there so much mathematical formulism in Economics? - Similar principle to raising your voice at a party. With stiff competition for jobs, positions in economic departments were often awarded to the most impressive use of mathematics. Thus, the bar was always been raised. To get noticed it is necessary to use more and complex mathematical equations. Thus the mathematics becomes a signal for an economist's competence rather than being intrinsically helpful to solve the problem in question (I'm sure many economists would dispute this)
3. Why Does the Practise of Splitting the Bill cause people to spend more at Restaurants? - When the bill is split the marginal cost to you of buying an extra garlic bread is very low. When the bill is split between 10 people, you only pay 10% of the cost. Therefore a £2 side order only costs an extra 20p; therefore, it seems cheap. If you pay for your meal directly you have to face the full £2 charge.

• Of course, it depends on the person; some people will be very sensitive to putting additional costs onto their friends. If the bill is to be split there is a significant social 'faux pas' of spending on the most expensive items. This is an example of one idea that can vary depending on who is involved with the meal.
  

• The Economic Naturalist at Amazon.CO.UK
• The Economic Naturalist at Amazon.COM

You May also be interested in:

• The Logic of Life by Tim Harford

Definition of Recession: A recession is a period of negative economic growth (falling Real GDP) for two consecutive quarters (6 months)

In practise people may feel the economy is in recession, even before it becomes 'official'. For example, if growth is very low or falls for 1 month, people will consider that to be a recession.

• E.g. the US economy is currently not officially in a recession (as of April 1st 2008) but many analysts talk as if the economy is already in recession. See also : Is US economy in Recession?.

More on: What Happens in a Recession

Causes of Recession

The main causes of a recession is a fall in Aggregate Demand. In the US 2008 recession, the main causes of falling aggregate demand have been:

• Falling House Prices. This reduces consumer wealth and prevents equity withdrawal through remortgaging. Also when house prices fall, people lose confidence in spending as their main asset is declining in value.
• Mortgage Defaults. Many homeowners were sold mortgage products that became unaffordable when their introductory period ended and interest rates increased. This lowered their disposable income and caused many to default on their mortgage payments.
  
• Financial Crisis. The prospects of banks like Northern Rock and Bear Sterns in the US going bankrupt have made people less confident about spending and investing.
  
• Credit Crunch / Difficulty of Borrowing Money. Because of high mortgage defaults in US, many banks lost money. Therefore financial institutions have become very reluctant to lend money, this has led to a shortage of funds in the money markets. This has caused borrowing to be more expensive and difficult to arrange leading to lower investment and consumer spending.

• Rising Costs. Rising oil, energy and food prices have caused an increase in the cost of production. This causes the aggregate supply curve to shift to the left; it leaves lower discretionary income for the average consumer.

For simple AD/AS diagrams on the causes of Recessions

See also: more reasons on Why the US economy is facing a recession

At other times the causes of recessions have been different see:

• UK recession of 1981
• UK recession 1991
  
• Black Thursday 1929

Other Questions and Answers on Recessions

1. Why Do some economists argue a recession can be a good thing?
2. How To Survive a Recession - Tips for consumers and firms to deal with an economic downturn
3. How Long Do Recessions Last? - There is no precise answer. It is difficult to predict how the forthcoming recession will last. An important factor may be how prolonged the housing price falls are.
4. On a related theme an essay on the Difficulties of Recovering from Recession
5. Did the Iraq War cause a recession?
6. Can Tax Cuts Avoid A recession?