In A Gallup Poll, published today 33% of Americans think the US is in a depression.

It is a reflection of the turmoil gripping the financial markets and housing markets that people have such a pessimistic outlook. Amidst tumbling share prices, falling house prices, collapsing banks and growing unemployment. It almost seems churlish to point out that, unbelievably, the US economy is still actually expanding.

The US is not in a depression. A depression would have to involve significant periods of negative growth and a much higher unemployment figure. But, whilst economists may argue over semantics and what actually constitutes a recession / depression, the salient point is that the US and global economy faces a real crisis. One of the worrying things about the current crisis is that it is all unchartered territory. We have had recessions before, but, they have been relatively predictable changes in the business cycle. The current crisis is unprecedented because the financial system is collapsing in a way never seen before. No one is exactly certain how it will develop. There is a lot of panic in financial markets and this panic is contagious. The outcome could be ugly.

In a way I am pleased the $700bn bailout got rejected by the house of representatives. The plan was ill thought out, based on tenuous economics. Wall Street deserves a bloody nose, but, whilst it is easy to knock a plan it is more difficult to suggest a solution.

• US Shares in Freefall after rejection of plan
• How does the stock market affect the economy?
• Effect of falling share prices on the economy
• Video - The effects of Falling stock market
• Video - The effects of Falling House prices
• Panic Grips World's Markets

Some commentators are suggesting that the current financial crisis could cause an unprecedented fall in the value of the dollar.

Reasons Why Dollar Could Collapse

1. Switching Reserves away from the Dollar.

The US is currently the world's reserve currency. Central banks currently hold upto 90% of their foreign reserves in the dollar. However, as the US economy and finance sector looks very weak, it makes sense for countries to diversify out of the dollar. If countries were to switch from holding reserves in dollars to holding reserves in Yen, Euros or others, it could spark a free fall in the dollar.

• Chinese banks told not to lend to American Banks.
• China threatens to sell Dollars

If China did sell its $1trillion dollar assets. It would cause a devaluation in the dollar and also higher bond yield rates. Higher interest rates are the last thing the US economy need at the moment.

There is also the danger of OPEC oil exporting countries shifting out of the dollar or at least not using their oil surpluses to buy US securities. (By the way, markets think this is more likely if Obama wins election)

2. US Debt increasing.

US debt currently stand at $9 tn or 65% of GDP. However, it is forecast to increase substantially Some argue National debt could soon pass 100%. This is because

• Financial bailout for subprime debt. If house prices continue to fall, if mortgage defaults continue to rise; the legacy of toxic debt could leave the US treasury facing unprecedented losses as it tries to bale out the system.
  
• Long term spending commitments on health care and pension will increase spending. Although, this has gained less publicity, in the long term, it could be more expensive than the current financial bailout. The Ageing population will increase the debt burden.
  

The problem with the increasing levels of debt is that the growing concern that the US government may start to default on its debt. If this ever happened it would cause shockwaves throughout the global financial situation and people would sell dollars. At the moment, countries like Japan and China have shown a willingness to lend the US money (buy US Bonds) at relatively low interest rates. But, if this confidence falls, nobody would want to buy any more US debt. This would cause a fall in demand for dollars and the value would fall. (Default by US Government is no longer unthinkable at Telegraph.)

To finance the growing national debt, the government may also just increase the money supply because they can't sell any more bonds. This would increase the money supply and inflation and also cause a depreciation in the value of the dollar.

3. Credit Crisis - Worst still To Come

The credit crisis and banking losses put downward pressure on the dollar because:

• They are forcing the US government to borrow more.
• Lack of Confidence in US financial markets which affects confidence in the dollar.
  

4. Current Account Deficit.

For several years, the US has been running a large current account deficit. This peaked at around 6.5% of GDP in 2006 (It has since fallen to 5% on the back of a weaker dollar.) Upto now the current account deficit has been financed by capital flows from abroad (mainly Asia and OPEC countries). If these capital flows were to dry up, as Asian countries no longer wanted to hold dollar securities, the dollar would fall.

5. Economic Recession and Low Interest Rates.

US interest rates are already low - 2%. However, if the economy was pushed into a very deep recession (e.g. growth of -2%) then there may be pressure for further cuts in interest rates. This would make the US even less attractive as a place to save money. Therefore demand for dollar would fall.

Reasons Why Dollar Will not Collapse

1. Fall against Whom?

The US economy is facing difficulties. But, so is the Eurozone economy, and Japan. It is not clear that any other country could cope with having a strong currency. US debt is high, but so is European debt. Japanese National debt stands at 195% of GDP, it makes the US look positively, frugal. The point is that although the dollar looks weak, so do most other major currencies.

2. Dollar is already weak.

Using purchasing power parity, the dollar is already undervalued against the Euro and Yen. Europe is already struggling with a high value of the Euro. If the Euro was to keep rising, it would cause further problems as the Euro economy slips into recession. This is why Gold looks such a good investment at the moment.

3. The Chinese don't want to lose All their Dollar Investments.

Because China have so many dollar assets, they have a vested interest in preventing a depreciation in the dollar becoming a rout. Also, China is aware that their economy relies heavily on exports to America. They wouldn't want that source of demand to completely dry up. Therefore China would like to avoid a collapse in the dollar - not out of altruism but self interest.

Conclusion.

The American dollar isn't a good investment. The dollar has depreciated by 40% in the last 6 years; and with the ongoing credit crunch affecting America the most, I would anticipate this steady decline to continue into 2009 and 2010.

At the moment, I can't see the dollar collapsing, if only because the US is not the only economy facing real weaknesses. However, there is a real danger US government debt could get out of control and they respond by increasing the money supply, which would devalue the dollar.

• US Dollar Forecasts for 2009
• Reasons for Fall in US Dollar - written last year but still valid
• The Effects of A devaluation in the dollar

Is it a good Idea to Charge People £10 to see the Doctor?

1. It would raise revenue to help improve health care.
2. It would reduce waiting lists
3. It would reduce time wasters.
4. It could increase social efficiency. - Free Health care may lead to over consumption.

In the below diagram social efficiency occurs at Q2. Therefore the price should not be zero. Of course, it depends on elasticity of demand and how much positive externalities there are.



Arguments against Charging to see the Doctor

1. Demand for health care is quite inelastic, higher prices would not reduce demand very much. There are not many time wasters who go to see the doctor.
2. Positive externalities of health care quite high
3. Going to doctor is merit good, especially for cancer screening
4. Would increase inequality
5. Cost of collecting the money.
6. Only a small % of total NHS cost.

Paying for prescriptions is a way of paying to see the doctor.

• Disadvantages of Private Health Care
• Benefits of Private Health Care
  

Labels: healthcare



Today, I wanted to offer a video blog for a change. It is a short introduction to some of the main reasons behind the current economic downturn. The analysis focuses on UK, but could easily apply to US and Europe.
I have a Youtube video channel - Economics Help. It is mainly focused on videos for helping A Level students

• What Went Wrong with US Economy
  
• UK Recession 1981
• UK Recession of 1991-91
• Causes of Recession

• On 24 Sept 2008, the total amount of US National Debt stands at $9.7 trillion or $9,789,212,150,663.03. It is forecast to rise to $11.3trillion by end of next year.

• This equates to $32,118.36 per person.

US Debt as a % of GDP Chart

This is perhaps a more meaningful measure of GDP. If National Debt increases 1% every year, but GDP increases by 2%, the National Debt will become a smaller % of the nation's output. You can see there was a huge surge in National Debt during the Second World War, which took many decades to reduce. From this graph we can see that National debt is not only increasing in real terms, but, increasing faster than the rate of economic growth.

• National Debt as a % of GDP increased sharply in 1980-1992, as Reagan and G.Bush increased military spending and cut taxes.
• The Clinton years were remarkable for achieving a rare budge surplus, helping to reduce the National Debt as a % of GDP. (This was helped by strong growth and fiscal restraint)
  

National Debt and Public Debt

Public debt is the actual amount the government owe in the form of bonds and government securities. National debt includes public debt + intergovernmental debt e.g. pension obligations, money owed to social security funds. An ageing population has increased the amount the government owe to its own pension funds.

Obligations not Included

When the Government effectively guaranteed Freddie Mac and Fannie Mae, they didn't included their liabilities on the National debt statistics. The argument is that they are basically sound companies. But, if they did lose more on mortgage defaults, it would increase national debt.

Forecasts for US National Debt

The current crisis will increase the US national debt because:

1. Bailouts for Banks and Finance companies e.g. $85bn loan to AIG. Paulson's $700bn bailout package.
2. Slowdown in growth causes lower tax revenue and higher spending on unemployment benefits e.t.c.
3. The National debt will be determined by the extent of bank losses, and how much the federal government agree to absorb.
   

Henry Paulson is asking for an increase in the legal ceiling on federal debt to $11.3 trillion or 70% of GDP.

However, there are concerns that a prolonged slump in the economy and house prices could lead to an even bigger national debt. If house prices keep falling and if unemployment rates rise sharply there could be even more defaults in mortgages. Given government intervention it appears that mortgage debt is becoming closely linked to National Debt.

Reasons for National Debt

1. Tax Cuts. During the Bush years, taxes were cut
2. Spending Increases. The biggest area of spending is on social security. Foreign intervention in countries such as Iraq have also increased spending.
3. Political Pressure. you don't seem to win an election by promising to balance the budget. There is a strong political incentive to promise tax cuts, but not to cut spending.
4. Ageing population. Demographic factors are causing an ageing population. Old people pay less tax and receive more benefits. The government is liable to pay an ever increasing Medicare budget
   
5. Cyclical Factors. Debt will increase in an economic downturn.
   

How Is National debt Financed?

The National Debt is financed by selling Treasury bills and bonds to the private sector. They are then bought by private individuals, investment trusts, pension funds. Some of these are bought by foreign investors e.g. Chinese banks with large foreign exchange surplus.

Foreign ownership of the National debt has increased to 25% of the total - How is debt financed
The biggest holdings of US National debt is:

• Japan $592bn
• China $502bn (China has a total of $1trillion dollar based assets)
• UK $252bn

Risk Of Debt Default

With increased liabilities in addition to the demographic changes, some feel that the small risk of the US government defaulting on debt has increased substantially. The credit swap on US debt has increased suggesting that markets think the likelyhood of debt default has increased. If this were to happen (or even if people felt it a real possibility, dollar assets would be sold causing a run on the dollar.) See: US is on verge of bankruptcy

Difference between National Debt and External debt

External Debt represents the amount owed by the US (both government and private) to other countries.

• Difference between Government debt and trade deficit

Effects of National Debt

• Higher Debt interest payments - debt interest payments amounted to $240bn a year. This is the 4th biggest form of government spending.
• Burden on future tax payers
• Reliance on country's like China to buy US debt. This makes dollar vulnerable to declining debt.
  

See: Effects of National Debt

Related

• Debt in the US - legacy of Bush
• UK National debt
• Government debt statistics
  

A battle is raging in Washington over Henry Paulson’s $700bn plan to buy bad debts from banks. Popularised as ‘cash for trash’ The sum is no insignificant amount – it equates to $5,000 per person in America.

One key issue is that the US Treasury will attempt to buy these debts from banks at close to their "hold-to-maturity" value, not the market value.

What this means is that the banks will be able to sell these debts for upto twice the market value. It is hoped that this injection of cash will avoid further liquidity shortages in the market.
In return, the US treasury will have lots of mortgage debts, many of which will be defaulted on, so they will lose money.
The US taxpayer, is rightly asking whether they are getting a good deal. In particular:

1. Will it work? The bailout doesn't address the fundamental problem of mortgage defaults. It merely tries to deal with the problem by buying bad debt.
   
2. As Paul Krugman was arguing here, why is the Government not getting a stake in the company’s it is bailing out?
3. How will the National Debt be affected by this programme of $700bn? - How much will the government be able to recoup if it spends $700bn on buying assets no one else wants?
   
4. Is there not a problem of Moral Hazard? If the government keeps bailing out failing banks and reckless investors, will not the problem keep reappearing? The plan also appears to benefit the banks who took on most risk and were least reluctant to write down their losses. 'Good' banks who didn't take on bad debt, benefit little.
   
5. Why are the manager’s of these failing banks still getting multi million dollar payouts? Even Lehman Brothers which went under, still managed to find $2.5bn dollars of ‘bonuses’ It does beg the question of how one can can possibly get a ‘bonus’ for going completely bankrupt.
6. How much power will Henry Paulson have in spending this enormous sum? He seems to be taken on extraordinary power to 'stabilise financial markets' As it is says in the short but terse 3 page document. 'The Treasury secretary's decisions "May not be reviewed by any court of law or any administrative agency."
   
7. Is there really no alternative as many on Wall Street seem to believe?

Of course, it is easier to criticise than it is to suggest a solution to the current financial crisis. But, nevertheless it is an extraordinary plan.

The continuing financial crisis increases the chance of an interest rate cut in the UK.

Basically, the MPC are caught between two conflicting pressures. Their fundamental target is low inflation. CPI 2% +/-1. Using CPI, they are clearly above the target (at 4.4%). Using a more comprehensive measure of inflation - RPI, which includes housing costs and council tax, inflation is running even higher at 5.1%. Given these statistics, in normal times, the MPC, would be contemplating interest rate increases. However, these are not normal times. Given the impending prospect of a recession and rapidly rising unemployment, the inflation target of 2% somehow doesn't seem so vital.

There are several reasons to argue that interest rates could fall significantly over the next 12 months, possibly to as low as 3.5%

• Inflation is forecast to peak soon and then drop back down. One important factor is the drop in oil prices. After reaching over $150 in early summer, the price of oil has fallen just as quickly (though with less coverage). At close to $100, we could see petrol prices and transport costs fall soon. This will make a significant improvement in inflation figures. Alone, this drop in oil prices could bring inflation back on target.
• With falling economic growth, the outlook is for lower demand pull inflation. In recession, firms usually respond by cutting prices to attract customers.
• There is evidence that the commodity price boom and food inflation is coming under control. This will also help reduce cost push inflation.
• Unemployment is rising at its fastest level since 1992. The recent banking troubles, will only add to the unemployment figures and create a negative multiplier effect, especially around London.
• Despite Central bank injections of money, the banking system is still short of liquidity. It is going to be difficult to borrow and finance mortgages. Lower interest rates, would help encourage consumer spending and give a little relief to the beleaguered housing market.

Given the raft of depressing news on growth and unemployment, the MPC, may decide to cut rates sooner rather than later. They will hope, that early rates will not cause inflation, but, will help mitigate the impact of an economic slowdown.

Problems of Cutting Interest Rates

Apart from inflation concerns, there are a couple of problems with cutting rates.

1. Moral Hazard. The financial sector has created problems by borrowing too much. Cutting interest rates aggressively, may just encourage these poor lending practises to continue. Arguably, the interest rate cuts in 2001 in response to the dotcom bubble, encouraged another boom. There is a need for a readjustment, in particular there is a need to increase the deplorably low savings ratio.
2. Interest rates may not have an effect. Textbook analysis suggests interest rate cuts will increase demand. But, it is possible interest rate cuts will fail to boost growth. If confidence is low, if house prices continue to tumble, lower rates may have very little effect in boosting spending. For a real example, one has to only look at the example of Japan, whose interest rates of 0% failed to avoid a period of deflation.

• Interest rates explained
• Why are there so many different interest rates?

Three interesting links for today.

Paul Krugman outlines why the US taxpayer is getting a bad deal out of the $700bn dollar bailout. Krugman makes a good point that if the taxpayer is going to spend so much money, at the very least, they should be getting a share in these companies.

• Cash for Trash by Paul Krugman
  

The other is a satire on bank Aid, courtesy of News Biscuit.

Sir Bob Geldof today launched a moving appeal to third world nations to ‘give whatever you can’ in the face of the ever worsening crisis in the western financial markets.

Addressing an audience of peasant subsistence farmers in Ethiopia, he urged Africans to ‘Give us your money. Pick up the phone and give us your ***ing money now. These people are losing their bonuses, their stock, their options… People are literally losing their liquidity right now and you have the power to stop it..’

How You Can Help Now

• £1 buys you 0.00000000001% of a derivatives traders annual bonus, which might not get paid this year.
• £500 buys you a round of drinks for the demoralised future traders to drown their sorrows in a prestigious soho Bar.
• £10,000 buys you 500 nearly worthless mortgage bonds, which used to be worth £3million.

Also, worth mentioning an idiot's guide to financial terms

Credit Default Swap - I’ll cover a bond that will never go into default in trade for a premium of several million dollars a year just in case it does, but there are no assets to back it up.

Leverage - opaque ways to hide the risk and get moneys available to you anyways as a business. In common usage, this means having $5.00 to buy $5,000,000,000 worth of stock, options, and/or properties, companies, bonds, physical assets.

Government Regulators - a group of friends that you hire to work in the government run office that covers your industry that agree with your way of doing things and are normally appointed by the people whose campaigns and campaign shindigs you funded.

Readers Question: When central banks "lend" such vast amounts of money as they have this week, where does this actually come from?, or are they in effect masking a confidence trick and in doing so shoring up the inevitability of depreciating currencies in future?

It comes from you the taxpayer!

When the US Government lent Insurance Giant AIG $85bn, it comes from the US treasury. In other words the taxpayer is liable. It is the same with the bail out of Freddie Mac and Fannie Mae and Northern Rock. If these firms fail and the loans are not recovered, then there will simply be an increase in the national debt - the taxpayer is liable. National debt is currently 65% of GDP in the US. This could easily increase to 85% if the government have to pay the total cost of all the bad debts it is taking responsibility for.

UK National debt is currently 40% of GDP, an increase in the national debt to 50% would not cripple the economy, but, it would be very expensive. Needless to say I doubt UK taxpayers will be happy to bail out the mistakes of millionaire bankers. This is why Gordon Brown was so keen on Lloyds TSB to take over HBOS, - it is a solution which doesn't require the exposure of more taxpayers money.

However, it is worth bearing in mind, if house prices stabilise, if home repossessions don't keep rising, if the financial system stabilises, then the government will not lose that much money. (although that is quite a lot of ifs! :) ) For example, in the 1980s, the failure of savings and loan banks in the US caused the government to intervene and buy all these bad debts. In the end, the government actually got a lot of the money back. Although they may have caused moral hazard into the process . Of course, the situation is different now, with house prices falling, the cost to the taxpayer is substantial. The main argument is that it would be much more costly without intervention

The effect of higher National Debt will be

• Higher taxes in the future
• Higher interest rates in the future.
• The problem is national debt is forecast to rise anyway because of ageing populations

The remote but potential risk is that the US government could one day default on its debt. If the US government became a bad debter, that really would be the end of the world. The dollar would collapse, the financial system would collapse, and in 20 years we would probably be all speaking Chinese :)

Readers Question: Due to recent events, the concept of short selling has been explained here and elsewhere, however, one thing that I don't understand is why driving the share price down necessitates an immediate bail-out or a merger of a bank.

Surely unless the bank has an immediate need to raise capital by issuing shares, it could just sit out the period of short-selling? I understand that low share price makes a takeover more attractive, but many such takeovers appear to be more a result of encouragement by government.

For many firms this would be true. The problem is the banks being 'shorted' actually needed to raise finance on the stock markets or in the money markets. For example, HBOS was so short of cash in the summer it is issued a share issue - trying to raise money by selling more shares; this was only partially successful, because people doubted its long term financial health.

The problem is that the bank's have balance sheets which rely on being able to raise funds on the money markets. In other words, they financed their loans and mortgages by borrowing on the money markets. When money markets froze they were in a pickle. The problem Northern Rock had was that it was simply unable to raise enough funds on the money markets (interbank lending) to meet its immediate need.

Also, the problem is that the short positions encourage people to sell who otherwise wouldn't. If people are betting the share goes down, who will want to hold onto them? Then, if a share price falls by 80%, financers feel that this bank is not a safe investment, therefore, no one will want to lend it money and then it will have further difficulties raising funds on the money markets.

It was hoped that Lehman Brothers would be able to raise enough finance to deal with its shortage of funds. However, at the last minute Korean investors pulled out not wanting to commit to a bank on the verge of going under. Maybe, if there hadn't been short selling and an aggressive decline in their share price they would have lent the money Lehman Brothers needed and just possibly, they would have been able to ride out the storm.

Some may say, they would have gone bankrupt even without short selling driving their share price down, and this is probably true. But, if HBOS share prices were driven down to 10p, it starts a panic to sell shares and no one wants to lend to the company. This only increases the chance it will become insolvent.

This is my understanding; although it is not my area of expertise.

The collapse in share prices of Lehman Brothers, Morgan Stanley and HBOS has led to an intense scrutinisation of the practise of short selling.

Short selling means you borrow a stock and sell it immediately. The hope is that the share will fall in value meaning that you can buy at a lower price than you sold it. And then give back the stock you borrow and make. A similar effect can be had with an option known as a put. This is simply the right to sell an asset at a given price. Thus if it falls you can sell at a price above the market value.

For example, suppose you think Lloyds TSB share price is overvalued at 335. You could enter into a short selling agreement. You would borrow say 1,000 shares from a broker and then sell them for 335. £3,350. If the share price falls to 200p. You can buy a 1,000 shares for £2,000 and give back the shares you borrowed and make £1,350 profit.

Furthermore, if you spread the odd rumour about the risk of the company, you will help to push it down. Also, if the market sees many people are holding 'short' positions, then this is likely to push the share price down. Therefore, holding short positions can be a powerful way to magnify the downward movement in share prices. It is said that short selling played a role in the troubles of Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers, AIG, Morgan Stanley and Goldman Sachs, as well as Europe's Halifax Bank of Scotland and Fortis NV.

Naked Short Selling. This is when you sell shares, you are not even sure you can borrow.

Regulation on Short Selling. There used to be a rule on Wall street where you could not hold short positions during a fall in share prices. This was known as an uptick rule. It meant investors could not pile into short positions on a share price in freefall.
Interestingly the US SEC Securities and exchange committee abandoned the uptick rule because they felt it was a constraint on market liquidity and did little to avoid manipulation.

However, many investors argue that the removal of the uptick rule has allowed hedge funds and investors to exaggerate any downward movement in share prices creating additional uncertainty over future share prices.

Will Stopping Short Selling Solve the Problem?

Short selling is really symptomatic of the problem rather than the cause. Stopping short selling will do nothing to alter the fact the global banking system is illiquid and short of funding. It will not stop banks going bankrupt. However, short selling can exacerbate problems creating additional uncertainty and volatility at a time when confidence is important.

• Financial Crisis
• The Free Market Fails
• Regulators move to crack down on short selling

• FSA list of Banned Companies for Short Selling

If there was one mantra of the past 2 decades it was 'free markets, deregulation and privatisation.' It is impossible to read any edition of the economist, without reading that the solution to every economic problem seemed to be simply - deregulation, flexible labour markets and more extensive free markets.

This ideology of deregulation was no more sacrosanct than in financial markets. Yet, the problem with giving the finance markets a free hand has been an unprecedented necessity for expensive and difficult government intervention to rescue the mistakes and disasters of unbridled free markets.

The Dot Com Bubble of 2000-01. You might have thought the Dot Com bubble would have sent warning signals about the irrationality of financial speculators. But, it was just seen as an unfortunate, one off event. The US government reacted by doing everything it could to avoid any problem. Interest rates were slashed to 1% - thereby sowing the seeds for the next boom and bust in housing. - A classic case of Moral Hazard.

Sub Prime Mortgage Debt. Remember the days when mortgage lending was backed by deposits and you actually had to prove a decent income. US mortgage salesman working for bonuses sold mortgages to all and sundry. The consequence was an unprecedented rise in mortgage defaults. Yet, the whole banking system seems to have not taken much concern about the level of risks. This toxic subprime debt was happily bought by banks around the world - rather ironically, transforming high risk debt into supposedly A+ safe loans. The fall out from the Credit crunch has led to many banks going bankrupt or needing a bailout.

Victims of Credit Crunch so Far

• Subprime mortgage companies filing for bankruptcy - New Century Financial, Net Bank, American Home Mortgages, American Freedom Homes e.t.c.
  
• Bear Sterns gets bought for $2 a share, with backing from government
• Merrill Lynch sold to Bank of America over fears of cash shortage
• Freddie Mac, Fannie Mae - nationalised by US Government
• Lehman Brothers - bankrupt
• AIG Insurance - required $85 billion loan from US government
• House builders in UK and US suffering grave difficulties.
• Northern Rock - ran out of funds required rescuing by Government
• HBOS - target of short sellers, needed unprecedented takeover by Lloyds TSB breaking up competition commission rules.
  

Government Intervention in Markets

• Government loans to banks in trouble
• Nationalisation of key banks like Freddie Mac
• New regulations to stop 'short selling'
• Governments pumping money into financial markets.
• Tax cuts to try reflationary stimulus. - Economic Stimulus Pact only partially successful.
• 31 March 2008 Sweeping range of regulatory changes gives the Federal Reserve the right to regulate financial institutions and intervene in financial crisis.
• New regulation on non-depository banks
• New regulations on mortgage lending

The amount of money the Fed has committed to underpinning the financial system is staggering. The 2 large Mortgage companies Freddie Mac and Fannie Mae have balance sheet obligations of $5bn alone. If these loans and guarantees are included as part of US National debt, it pushes up national debt from around 65% of GDP to 85% of GDP.

• Housing Boom and Bust
  
• Credit Crisis
  
• List of Subprime Writedowns
• Subprime crisis timeline at Wikipedia
  

Readers Question: (James) What kind of measures do you think the competition commission will be willing and able to take in the long term, after confidence has been restored and steady growth returns? Are there any comparable cases of the competition commission 'forcing' a large company apart?

The merger of HBOS and Lloyds TSB means one less high street bank, and a firm with monopoly power (30% of market) Basically, I expect the banking industry to remain less competitive for the foreseeable future.

As far as I know, the Competition Commission (and its predecessor the MMC) does not have a track record of forcing companies to split up. The Competition Commission is focused on deciding whether mergers are in the public interest. They can make recommendations before a merger. For example, they allowed Morrisons to buy Safeway on the condition of selling off some supermarkets. However, their remit does not involve breaking up existing monopolies.

One case, that I do remember is the Office of Fair Trading, after a report by Competition Commission required Interbrew to get rid of some parts of its business in 2001. Basically, interview bought Bass brewers in June 2000, and in January 2001 OFT said they need to sell off parts of its business. BBC link  

The OFT, can investigate firms who 'abuse their dominant market position'. or engage in unfair competitive practises (e.g. predatory pricing). But, these can be difficult to prove. A recent investigation into supermarkets by the OFT, basically said they were fine.

Could Lloyds TSB HBOS be Broken Up in the Future?

With 30% of the market share in Mortgages and savings they do present substantial monopoly power. British consumers will be less worse off by the deal, it will be easier for Lloyds / TSB / HBOS to charge higher rates to borrowers and lower rates to savers. This will be a particular problem during the continuation of the credit crunch.

It will be difficult for the competition commission / OFT to act retrospectively. It would need a change of legislation to break up monopolies like that. It may be a populist move with the general public, but, it would leave a bitter feeling amongst Lloyds TSB. In a way they are doing the government a favour by buying HBOS, - I wouldn't be surprised if Gordon Brown somehow gave a guarantee that the merger would not be challenged in the future. How binding this agreement would be it is difficult to say.

The Winner is - Lloyds TSB

Lloyds TSB will be very happy with this development.

• They wanted to take over Abbey in 2001, but, were blocked by the Competition Commission because it would have reduced competition (As it is the HBOS merger creates an even bigger company.
  
• They bought HBOS for a low price 232p. If the credit difficulties are eased, then it is worth remembering HBOS / Halifax has a very profitable commercial bank. E.g. in 2006, HBOS made £4.3bn profit.
  
• Even in the very unlikely situation they were forced to sell off parts of the business (when the crisis has passed) I'm sure, they would be selling at a profit. The buying price of 232p reflects the uncertainty of current difficulties. When (if) these are removed, it looks great value.
  
  

In normal times, it is inconceivable that a British Bank would be allowed to merge to gain over 30% of the market share for mortgages and savings. However, given the state of the financial markets, the government had no option but to allow the merger to go ahead.

After the £12bn merger of Lloyds TSB and Halifax is completed, the new bank will have nearly 33% of the retail banking market. This places it well ahead of its rivals like Abbey and Nationwide, who have 10% of market share.

The last big British banking merger was in 2001 when Lloyds bid for Abbey National. However, in 2001, the Competition Commission blocked the merger on the grounds it would harm consumer interests.

Effect of Merger on Public

• The increased market share will reduce competition in the long term. Lloyds TSB will be in a position to charge higher rates to mortgage customers.
• Your halifax Savings are Safe. With 30% of the market, Lloyds / TSB / HBOS is safe. There is no need to withdraw money.
• Bank Closures. The new firm is likely to rationalise its branches. There could be many job losses upto 40,000 job losses are feared.
• For people with mortgages at the Halifax, your mortgage will not change until the end of your negotiated contract. At the end of your current mortgage term, you will have to get a new deal. This is likely to depend on market conditions. With uncertainty surrounding financial markets, mortgage rates are likely to be higher. Lloyds could also use its market power to set higher rates.

Rather ironically, AIG, are still sending out a mailing list recommending people get insurance for the time 'disaster strikes'. (This is on the day, when they received a $85billion loan from the federal government in return for an 80% stake) The problem is when the insurers and supposedly reputable banks are going under , who can you get insurance from?

If the extent of bailouts, emergency loans and rescue packages has your head spinning, you may appreciate this humorous look at how the credit crisis started (courtesty of the Long Johns on BBC - video)

It is an extraordinary time for the world's Banking system.

First, the US subprime mortgage companies, then Northern Rock, Bear Sterns, Freddie Mac, Fannie Mae, Lehman Brothers, AIG and others (it's hard to keep track), have either been rescued or allowed to go under.

Now HBOS (owners of Halifax) and investment banks such as Morgan Stanley are facing serious question marks about whether they can survive.

The government will not want to let a commercial bank like Halifax go bankrupt. The disruption to the financial system and economy would be too great. They will risk taxpayers money, rather than risk a financial meltdown.

Nevertheless, as many have been asking, if the unthinkable happened and a Bank like Halifax did collapse what would happen?

Mortgage. - You would still have to pay your mortgage. The liability would be bought by another organisation. (The administrator of the bank will try to collect as much as it can). Not much would change, you would simply pay your mortgage to another company. However, at the end of your mortgage deal, you may face a much higher interest rate.

Savers. In the UK, the first £35,000 of your savings are guaranteed. But, after that you could lose everything.

Mortgage Market. It would get even more difficult to get a mortgage, as their would be fewer banks to lend money. It would be bad news for a stagnant housing market and house prices would fall even further.

Unemployment. A bank like Halifax employs thousands of staff across the country. Even a merger between Halifax and Lloyds TSB could lead to upto 5,000 job losses.

Confidence. If a bank like Halifax went bankrupt and savers were left out of pocket. It could lead to a classic run on the bank, savers at other banks would worry that there bank could be next. If people did go to take their savings out, the banks would simply be unable to honour the demands. The deposits are tied up in long term loans like mortgages which they can't get back. It is this confidence in the banking system the government will feel almost obliged to protect.

Recession. With the economy already entering into recession, a banking collapse, would cause further unemployment, falls in spending and lower economic growth

Related

• Banking collapse and the withdrawal of money
• Why Do banks get bailed out
• Bailing out the banking sector and Moral Hazard

The standard text book definition of a recession is:

"Negative Economic Growth for two consecutive quarters". This means there must be a fall in real output for a period of 6 months.

However, not all economists are happy with this definition. Why?

1. Population Growth: If the population was increasing by 1% a year. Real GDP growth of 0.5% would mean Real GDP per Capita was falling. This is an important factor for countries like the US which have growing populations.
2. Statistics can be inaccurate. Often GDP statistics are inaccurate and need to be revised down. Therefore, growth of 0.3% could actually mean growth is falling 0.2%. However, figures can be rounded up as well as down.
3. Growth Below Trend Rate. If capacity grows by an average of 2% a year, then economic growth of 0.8% a year, would mean a rise in spare capacity and therefore, unemployment is likely to rise. Therefore, some economists feel we should call a recession, if spare capacity is rising. However, the problem with this is that it means economic growth of 1.0% could be classed as a recession, which creates confusion. Some economists refer to a 'growth recession'. Low growth compatible with features of recession.
4. Unemployment. Arguably, a distinguishing feature of a recession is rising unemployment. If unemployment rises significantly, then this signifies the economy is in recession. It would seem churlish to say the economy was not in recession, if unemployment has risen by 0.5 million but, growth is just about positive. However, how much unemployment would have to increase by? Also, unemployment could be caused by supply side factors, rather than demand side factors.
5. Survey. You could ask a survey of economists / people, whether they think the economy is in recession. But, this is very subjective. At the moment, 53% of economists think the US in in recession, but, 47% don't - how helpful is this? (see: Why is the US not in recession?)
   

US Definition of Recession.

In US, a recession is said to occurs, whenever the National Bureau of Economic Research NBER says so. There definition is:

..... a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.

NBER further tells us that:

"There is no fixed rule about what weights are assigned to the various indicators, or about what other measures contribute information to the process."

This clearly is injecting a lot of subjectivity into the definition. I appreciate the reasoning behind the statement, but, it creates uncertainty as to what will cause a recession.

How I Would define a Recession

I believe a real recession requires a fall in real GDP. If growth is very low 0.5%, we can talk about the economy being nearly in recession, or below trend growth. But, we should stick to the definition that a recession requires a fall in GDP for at least one quarter.

I would be sympathetic to defining a recession as a fall in Real GDP per Capita.

Definition of Depression.

'When you lose your job..'
A depression is seen as a very dramatic fall in real GDP. Perhaps when Output falls for more than a year and a half or by more than say 5%. In the Great Depression of 1929-33, output fell by 18%

External Links

• Definition of recessions - Why recessions should not involve upward growth
• Economist.com argues negative growth is inadequate defintion

Further Reading on Recessions

• Can US and UK avoid recessions?
• How To Avoid A recession
• What Does it mean to be in a recession?
• How Long Do Recessions last?

We teach the Great Depression as history. We teach that after so many American banks went bankrupt in the 1930s, the government instituted proper regulation so that banks would never be able to fail and confidence will always be maintained in the banking system.

For a long time, this notion of banking infallibility was well ingrained in the national psyche. It was just taken for granted that banks made huge profits, and were immune from collapse.

However, with the collapse of Lehman Brothers, even leading economists, are warning of a very real possibility of a financial collapse, not seen since the 1930s.

Lehman Brothers is not a traditional deposit style bank. It is an investment bank which got involved in bundling loans from banks and selling them on through the banking system. They also got heavily involved in the fast growing derivatives market. It was once thought that this 'shadow banking system' would help reduce risk within the banking system. Alas, the reality seems to be it just created a black hole for risk to be completely ignored.

Despite slipping into Rumsfeld speak, (...And as the unknown unknowns have turned into known unknowns, the system has been experiencing postmodern bank runs...) Paul Krugman does a good job in explaining why the collapse of Lehman brothers highlights the growing uncertainty around the financial system.

A year ago, Northern Rock had queues of nervous savers coming to take out their life savings. However, most of the modern day bank runs occur when nervous investors try to unwind their positions. What this means is that they want to withdraw their loans to other banks, as they are nervous of losing the money. The consequence is that there has been a shortage of liquidity in the financial system, exacerbating the problem of loan defaults by consumers.

Yesterday, the Bank of England and Federal reserve were forced to inject money into the system. The Bank of England injected £28bn, but, this was still not enough to prevent the libor (inter bank lending rate increase by 0.5%.

Recession and Banking Collapse

The last thing the banking system wants is a global slowdown. But, that is precisely what is likely to happen. As the US and Euro economy slips into negative growth, unemployment will rise causing home repossessions to rise even further. This will lead to further bad debts for banks; it could be the straw which brakes the camel's back.

House Prices and Financial System

American house prices have been falling for over 2 years. But, the concern is that European, Australian and other countries house prices could follow suit. Certainly house prices in Ireland and Spain are overvalued; these could fall significantly leading to more negative equity for the banking system to cope with. It is true, european lenders are not exposed to the same subprime mess as in America; but, falling house prices will hardly help the situation.

Financial System and Confidence

We cannot underestimate the importance of confidence in the financial system. If people don't know whether banks will survive, investors will be too nervous to lend money. Therefore, we will get a further contraction of interbank lending, exacerbating any underlying problem of poor balance sheets.

Related

• Who is to Blame for credit crunch?
• Bailing out the banking system and moral hazard
• Banking collapse and the withdrawal of money
• Boom and bust in US housing market
  

In the past 2 months, the US dollar has staged a strong rally.

• For example, in July 1 Australian dollar was worth $0.98 US. By, August 30, this had fallen to 0.78 - quite a marked fall.
• In July 1 US $ was worth 0.62 Euros. By Sept 10 this this had risen to 0.71 Euros.
• In July 1 US $ was worth £0.5 By September 11th this had risen to £0.57
  

Why has the dollar appreciated? and is the appreciation temporary or permanent?

Firstly, the US economy is weak.

• Growth is slowing down (annual growth rate of around 1.3%)
• Interest rates are very low (2%)
• Unemployment is rising
• Current account deficit is still a high % of GDP (despite recent improvements)
• Concerns over Financial system, highlighted by the failure of major banks
  

From a textbook analysis, America has all the ingredients of a weak currency.

The main reason for the dollar's appreciation is the realisation that maybe the dollar has been oversold in its long bear market since 2001.

The other important reason is that there is a growing awareness the economic troubles which began in the US, have spread to the rest of the world. In fact, it appears that the Eurozone will be the first to enter an 'official recession'.

The dollar's recent strength is therefore not a thumbs up the underlying economic conditions of the US, but, a reflection of the European slowdown. (see: Euro economy first into recession)

With US interest rates at 2%, there is little further that they can fall (especially with inflation nudging towards 5%). However, in the Eurozone, interest rates are more than double that in US. The slowdown in the Euro economy has been quite marked and it raises the real possibility of lower rates in Europe. It is these lower interest rates in the UK and Europe that will reduce demand for the dollar.

Prospects for US Dollar in 2009

The US, has so far avoided an official recession (helped in part by a weak dollar, which has boosted exports). However, the credit crunch shows no signs of reaching the bottom. 2009, is likely to bring more bad news for the economy. How many banks will need rescuing like Freddie Mac and Fannie Mae? The economy will slowdown further in 2009, and this will make the dollar weaker.

However, with a global slowdown, the US dollar will not be much weaker than other currencies.

This short term appreciation in the dollar does not reflect a return to a strong dollar. This will only come if the US can overcome fundamental problems such as:

• Structural current account deficit
• Unbalanced economy - high debt both private and public
• Problems in Financial sector. How many more banks will go under? Can the financial system cope?
  

One of the issues I often teach is how house prices affect consumer spending and economic growth. The logic is:

• House prices are the biggest form of consumer wealth in UK and US.
• A rise in wealth causes rising spending because:
• Increased wealth increases consumer confidence.
• Higher house prices enables you to remortgage against the value of your house and spend the equity released.

Similarly, a fall in house prices will reduce consumer spending.

This simple analysis seems to be backed up by empirical evidence. Falling house prices seem to coincide with periods of economic downturn.

• In 1991, house prices fell 15%, pushing the economy into a deep recession (growth fell -2% in 1991)
• In 2008, house prices have fallen 10% and the UK again looks set to enter into recession. The US has had a delayed reaction, but, it is widely agreed falling house prices have contributed to lower consumer spending.

I was interested to read a study by, Willem Buiter, (see: Home Truths at Economist.com) a former member of the MPC, who claimed that house prices actually have no wealth effect at all. His argument is:

• Most people buy a house to live in. Whether house prices rise or fall makes no difference because the purpose of a house is not to provide equity gains and income.
• Some people may be affected by falling house prices. E.g. investors who are 'long' on housing. i.e. their ownership of houses is not just for living but gaining rentable income. However, Buiter argues that, these investors are offset by people who benefit from falling house prices. For example, first time buyers will be able to spend more on other items, if house prices are lower.
• Therefore, overall, changes in house prices do not affect consumer spending.

The fact that house prices fall just before a recession, confuses cause and effect. You could argue house prices are falling because consumer's incomes are being squeezed (high interest rates '91) (credit crunch '08). Therefore, it is the economic downturn that is causing house prices to fall rather than falling house prices that cause the recession.

Who is Right - Do House Prices Really Have No Effect on the Economy?

In my case rising house prices didn't cause higher spending, and falling house prices hasen't reduced my spending. However, I still doubt Buiter's reasoning. This is why.

1. In the consumer boom of 2001-2007, equity withdrawal played a significant role. For example, in quarter 4 of 2006, Mortgage equity withdrawal equalled £14.5bn or 7.3% of disposable income. (Bank of England MEW stats) This may seem only a small % of AD. But, since house prices have fallen and people are facing negative equity, this cause of consumer spending has dried up. It has provided an important catalyst for reducing consumer spending. See also previous post (equity withdrawal and economic growth)
2. Most people own a House. 75% of houses are owner occupied. In other words when house prices fall, far more people lose out than gain. True, some first time buyers will be better off because of falling house prices, but, these are outnumbered by existing homeowners who see a fall in house prices.
3. Some forms of wealth / assets have little impact because they are held by high income earners whose spending does not depend on share prices. Therefore, when share prices fall, most people don't reduce spending because most people don't own shares. But, falling house prices affects most income groups (especially since home ownership was extended in the 1980s)
4. House Prices have become an important barometer of the state of the economy. House prices make front page news. Every monthly fall is reported with great vigour and excitement by the media. People have created a link between the housing market and the state of the economy. Falling house prices are generally seen to reflect the state of the economy. Therefore, falling house prices do contribute to a fall in consumer confidence and consumer spending.

Buiter makes an important point that we often forget those who gain from falling property prices. Falling house prices are good for young people. The problem is that during this period of falling house prices, the gains have not materialised because falling house prices have been accompanied with a tightening in mortgage lending. Therefore, although house price, first time buyers don't actually feel it is any easier to buy houses.

Related:

• The Effect of the Housing Market on UK Economy
• Negative mortgage equity withdrawal
  

Readers Question: According to Emerson: “want is a growing giant whom the coat of Have was never large enough to cover.” According to economist, why does “want” exceed “have”?

This strikes at the fundamental problem of economics – a scarcity of resources. Because there is a scarcity of resources, our desires (wants) are greater than available resources. Therefore, economic issues spring from this fundamental problem of deciding:

• What to produce
• How to Produce
• For Whom to produce

When making decisions about what to produce or what to consume, there is inevitably an opportunity cost. If a society spent 50% of its GDP on military spending, the opportunity cost is that it wouldn’t be able to spend very much on health and education.

Public opinion may call for an increase in spending on health care. For example, there is an expectation that expensive (but potentially life saving) drugs should always be available. But, people often forget that resources are limited and an opportunity cost is involved. If we give very expensive drugs to old people, it means we may not be able to spend money on road safety campaigns which actually do more to save lives.

If you have a limited income of say £20,000 a year, you are constantly making choices about the best way to spend your limited income. Even millionaires may like to consume more if they could only become billionaires.

Is it Possible to Have no Scarcity?

If you lived on an island with abundant resources and a small population, then the scarcity of resources would be less obvious.

If through spiritual practise and detachment you had very few desires – for example a monk or sannyasin then you would not see scarcity – as you would be content with just your daily bread. But, in present society, most people desire more than just a loin cloth and a begging bowl. So we keep coming up against this issue of scarcity.

Environment and Scarcity.

Environmental issues have highlighted this issue of scarcity. Previously we considered scarcity in terms of lack of resources, but, increasingly we are aware of how depletion of the environment increases the problem of scarcity.

Does Society Increase Wants?

Another issue is the extent to which society artificially increases the desires of people. For example, advertising may be adept at creating additional demand for goods that they don’t really need. Sometimes ‘primitive tribal’ societies appear quite content with a simple lifestyle. But, here in the West, the more we have, the less satisfied we seem to be.

BTW: There is an excellent film – The Gods must be Crazy. An African tribal society leave in peace and contentment until the arrival of a coke bottle from the sky causes friction and anger. Very funny.

This all sounds very much like my first economics lesson to a new student. I hope it doesn’t sound too patronising.

Readers Question: Why is it okay for Curtis Mathes Corporation to go belly up, but not an airlines, or a car company, or a bank?

It is an interesting question.
- Why does the government rush to rescue those companies who caused the current financial crisis through their own bad management?

Curtis Mathes is an electronic company. At their peak they had 3,500 employees. If a company like this goes bankrupt, it has no macro economic effect. In other words, the bankruptcy causes pain to individuals, but, doesn't really affect the wider economy.

In the case of a bank there are very good reasons to prevent, even one bank, from going bankrupt. The problem is that if one bank goes under, people lose confidence in the banking system. You would see savers queueing up to take out their deposits. But, the banks would not have enough cash to meet the avalanche of deposits. Banks only keep a small % of their reserves in cash - about 1%. This is because it is more profitable to lend out money - on which they can earn interest rather than keep it in a big safe. Banks rely on the fact most people do not suddenly demand all their deposits. But, if confidence in the banking system collapsed, people would want to withdraw. Just last year, the UK saw queues of savers trying to get their money out of Northern Rock (even though there was little necessity to do so). Eventually the government had to guarantee all the savings.

In a previous post, a reader asked - what would happen if all the customers required their deposits? - Banking collapse and the withdrawal of money

Note: In the Great Depression of the early 1930s, many medium sized banks did go bankrupt because there was no mechanism in place to secure all their funds.

What Would Happen if Freddie Mac and Fannie Mae went Bankrupt?

The main thing is that it would be very difficult for American banks to finance any new mortgages, especially in the current climate. Banks would struggle to raise the finance for lending, so would rely on their own saving deposits which would be insufficient.
The banks would have to increase the cost of mortgages and also require much bigger deposits.
This would cause a further fall in demand for houses and further price falls. This would exacerbate the economic slowdown and cause a more serious recession.

Should Governments Rescue National Airlines?

This is a disputed point. I think governments often rescue national airlines out of a sense of national pride (Swiss Air springs to mind). They are big employers, but, they don't have the macro economic impact that banks do.

Readers Question: Interesting article (Nationalisation of Freddie Mac and Fannie Mae). But could you explain what do you mean by "The banks need to be nationalised because of an unprecedented rise in mortgage delinquencies (an American term for mortgage defaults) leaving investors nervous about whether they could survive." Who could survive? The investors, or the banks. - William Wallace

The markets were concerned that the big two banks were at risk of becoming insolvent under the weight of bad mortgage loans. Between April and June they lost over $3bn. They tried to raise money on the financial markets, but, this was becoming difficult because nobody wanted to lend them money with more losses still to come.

The two mortgage lenders supply funds to nearly all major US banks and mortgage companies.

It is to prevent the two big mortgage companies going bankrupt that the Fed effectively nationalised the Bank. Existing shareholders in Freddie Mac and Fannie Mae, will be the last to be reimbursed. It means if losses mount the old shareholders will probably lose everything. (The Share price fell to $1)

Good article here at BBC - Freddie Mac and Fannie Mae

It is interesting that government's who often profess a philosophical support for laissez faire capitalism, often end up doing the exact opposite. The Thatcher and Reagan governments both professed a support for laissez faire economics, yet both increased real government spending and government borrowing.

The Bush administration, presumably supports laissez faire capitalism, so it is something of an embarrassment for them to have to undertake the world's biggest financial bail out in history. The multi billion dollar rescue of Fannie Mae and Freddie Mac is effectively nationalising the US's biggest mortgage companies.

It is reminiscent of the UK's nationalisation of Northern Rock. For a long time government ministers tried to avoid the 'N' word; but like in America they were ultimately, left with no alternative.

The banks need to be nationalised because of an unprecedented rise in mortgage delinquencies (an American term for mortgage defaults) leaving investors nervous about whether they could survive.

In a way, the US government cannot contemplate allowing the two big mortgage lenders to go under. They are involved in over 50% of US mortgages and so are an indispensable part of the financial system.

However, the cost of the bailout is uncertain. Henry Paulson, the US treasury secretary admitted that . "In the end, the ultimate cost to the taxpayer will depend on the business results."

Basically, if the credit crunch lasts into 2010 and mortgage defaults continue to rise, the American taxpayer could be left with a very large bill for the financial bailout.

It is hoped that government nationalisation will reassure investors who know their loans will be secured by the government. However, the worst of the US housing market downturn is not over yet. Defaults in subprime mortgages are also spreading to prime mortgages, - especially mortgages based on adjustable rates. With house prices still falling, mortgage defaults also leave banks with significant losses.

Related

• Nationalisation of Northern Rock - What it means
• Arguments for Nationalisation (in general)
• Northern Rock rescue plan

As regular readers know, I often advocate specific taxes on goods with negative externalities or 'unintended consequences' such as: food tax, petrol tax, alcohol tax and parking tax.

This is a humorous piece from Freakonomics on a suggestion for a Tax on Sex

+ It has been observed that Democrats are generally in favor of taxation and Republicans are generally opposed to unnecessary sexual activity; and whereby:

+ The unintended costs of sexual activity are unacceptably high, particularly in the political arena (c.f. Messrs. Clinton, Foley, Craig, Edwards, and most recently one Mr. Levi Johnston, to name just a fraction of the available examples); and whereby:

(I think some of the comments were taking it a bit too seriously!

House prices in the UK are falling at the fastest rate since the Great Depression. There is a powerful momentum for falling house prices. Predicting house prices for 2009 is difficult, but, I think in the short term, they will keep falling - House price forecast 2009. The US by contrast may at last be beginning to see a moderation in house price falls.

The start of the academic year has seen an increase in readers questions. I often get asked about the Difference between Economics and Business Studies.

It would be a heartless soul who wanted to stop federal aid to places devastated by floods. Yet, are there any good economic reasons for appearing to be heartless?

Some areas are very prone to flooding (e.g. New Orleans) Because they are prone to flooding, house prices will be lower than average. Therefore, vulnerable areas of housing often attract low income households. Therefore, when floods hit the area, it is the poor who are disproportionately hit.

In response to devastating floods, the federal government may respond by guaranteeing the cost of rebuilding. This seems fair because:

• The poor cannot afford to rebuild.
• It spreads the cost of floods across the country.

However, although this has the best intentions, there is a problem of moral hazard. Because the government guarantees the cost of rebuilding, houses in these vulnerable areas more or less retain their value. It also encourages people to continue to live in vulnerable areas.

If the government, didn't secure them against flooding, their price would fall significantly; this would mean the poor who live there would have lower housing costs.

Therefore, the effect of Guaranteed government relief is:

• Deals with short term problem
• Makes long term house prices in vulnerable areas higher than they should be.
• Encourages people to continue to live in unsuitable areas.

What Then Should The Government Do?

It is easy to point out problems of subsidising rebuilding, it is more difficult to suggest long term solutions.

Maybe the government could give those affected credits to buy housing anywhere they like. Many may take the opportunity to move elsewhere where the risk of flooding is less. Because the government isn't promising to rebuild in vulnerable areas; house prices would fall making it cheaper for those who continue to live there. But, people will be less inclined to live in a vulnerable areas where nobody is going to insure it.

• Therefore, the next time the flood comes, the impact and cost will be much lower, because many people will have drifted away.

I am not arguing for a policy of laissez faire. Government should deal with catastrophes and disasters. I don't mind paying higher tax to fund disaster relief. At the same time, we should not be blind to the long term consequences of giving aid relief and insurance. It is good to give aid, but, it is better to give Aid thoughtfully and try to diminish the future problems of aid.

The inspiration for this article came from - "More Sex is Safer Sex" by Steven Landsburg.



"More Sex is Safer Sex" at Amazon.co.uk

The Chancellor of the Exchequer, Alistair Darling, recently said that the UK economy was facing its worst period for 60 years. I don't agree with this assertion; and am surprised a senior minister wants to exaggerate the weakness of the economy. But, nevertheless the economy is doing badly, and the UK's proud record of 63 consecutive quarters of economic growth is finally coming to an end. What has caused this downturn and who, if anyone, is to blame?

The Credit Crunch

Undoubtedly, the unexpected freezing of credit markets has played a critical role in reducing consumer spending. The freezing of credit markets hit the UK mortgage and Housing market very badly and this has caused a contraction in consumer spending. To a large extent, the UK government can claim that this was an issue beyond their control. After all, the UK government can hardly be held responsible for bad lending and defaults in the US subprime mortgage sector. However, the UK, is far from blameless. On a lesser scale, UK banks have made a series of bad lending decisions, typified by the business plan of Northern Rock which led to the necessity of a government guarantee. Like the US, the UK has trusted too much in the self regulation of the banking system and has not done enough to ensure checks and balances in the banking system.
(see: who is to blame for credit crunch)

Cost Push Inflation

Consumer spending has also been squeezed by rising prices. The UK government can claim that the cost push inflation, is a global phenomena beyond their control. Rising oil, food and energy prices have pushed RPI inflation up towards 5%. However, this inflation is not really of the government's making. There is little that the government or Bank of England could have done to avoid this. This contrasts with the last spike in inflation (see: The Lawson Boom) - in the early 1990s when the economy was allowed to expand too quickly.

Mistakes of the Government

1. Debt Levels. In the past few years, the Government have increased national debt as a % of GDP due to higher government spending. The high levels of national debt now leaves the government with little room for manoeuvre.
2. Unbalanced economy . Economic growth was maintained mainly by high consumer spending, low savings and rising house prices. Personal debt rose to record levels. UK manufacturing has been relatively weak, leaving a persistent current account deficit.
3. Rhetoric. The government were keen to paint a rosy picture during periods of growth. Their persistent self congratulatory rhetoric, was not entirely undeserved, but, it did make them complacent about longer term problems such as debt levels, manufacturing and productivity growth. Now that the economy is slowing down, it hardly helps to exaggerate their own problems saying it is worse in 60 years.

The Impact of a Recession

I spent the last 2 weeks in New York where I had a break from writing Economics; although on the plane I wrote quite a few posts, which was due to a pretty dire selection of videos on American Airlines and the amazing Apple Mac battery life. These are some random observations from the US.

• The Housing Crisis is pretty much in evidence. Foreclosure doesn't just have an economic impact but profoundly personal impact on those affected. It is a big issue for many of my friends in the middle class district I stayed. (Boom and Bust US Housing) At least recent signs suggest the slump may be losing its severity with a potential for recovery in 2009.
• The Airline industry is struggling. I only narrowly avoided buying a ticket with the bust airline Zoom. With less competition and higher oil prices, it will become easier for airlines to justify higher ticket prices.
• American Food Sizes are Big. I really understand why America has a problem with obesity now.
• Things are Cheap. In the US, you can get a good breakfast for $5 (breakfast special and coffee). In the UK, this would typically cost £6 ($12 on old exchange rate of 2:1. - Perhaps not surprising the Pound has been falling.(See: Price of Mac)
  
• Why Does America not include sales tax in the price? In the UK, the price you see is the price you pay. In America the price you see is usually not what you pay. A bottle of water is advertised for $1.99, sometimes you will pay $2.26, other times you will pay $1.99

The tax is inefficient for various reasons:

1. Time wasted of shop counting change
2. Shops have to keep more change
3. Uncertainty for customers not knowing how much to pay.

The obvious solution would be to make it compulsory to include tax in the final price, I wonder why they don't do it.

• Advertising for Health Care. I was struck by how much advertising for health care you see in America. In the UK, it is pretty rare apart from some BUPA ads. The high levels of advertising are ultimately paid for by the higher price of health care.