Readers Question: A Few years back when US cut interest rates drastically to recover the economy from dot com bust, it leads to a boom in the housing market and created another bust. Currently US has cut the interest rates again drastically to 1%, wouldn’t it create another boom and bust? Thank you.

Graph of US Interest Rates


It is a very good question.

Firstly, you are right that the cut in interest rates did facilitate a boom in house prices in the period 2002-2006. This boom in house prices came to an end in 2006, and as house prices fell in 2007-08, the negative wealth effect pushed the economy into recession.

Boom and Bust 2001-08

• The dotcom bubble burst in 2000-01, also the events of 9/11 left the US facing a serious downturn.
• The Fed acted decisively to cut interest rates to 1%. This helped the economy avoid a serious downturn and the economy soon recovered. Many praised Alan Greenspan for his decisive action to avert recession, during a real crisis for America.
• However, look how long interest rates were kept at 1% - until the end of 2004.
• Because interest rates were so low. Buying a house was really attractive. Rising house prices and interest rates of 1%, encouraged US mortgage companies to offer a mortgage to every Tom, Dick and Harry. (better known as subprime mortgages).
• Rising House Prices also caused a boom in new house builds.
• However, by 2005, the Fed started to respond to rising inflation and a booming economy. Interest rates were increased to 5.5% by 2006. (See: Boom and Bust in US Housing Market)
  
• This increase in interest rates meant that many who took out mortgages at 1% couldn't pay the mortgage back. They defaulted causing losses to the bank, and the financial crisis we see today.

Will A Boom and Bust Happen Again?

Now we have seen interest rates cut back to 1%, could we be in for another rollercoaster? - another boom and bust?

• It could happen. People soon forget busts. Boom and busts occur with a certain regularity.
  
• Behavioural economists note how often people engage in herding behaviour. (if asset prices are going up, everyone jumps on bandwagon. When asset prices fall, everyone sells)
• You could argue that the financial bailout of the banks encourages moral hazard. i.e. the banks have lost billions but, they can rely on the taxpayer to bail them out.

Why It Might Not Happen

• The boom in house prices was not just caused by low interest rates. It was also caused by irresponsible lending by subprime mortgage companies. I cannot see this kind of mortgage lending returning for the foreseeable future. One assumes the US has instigated better legislation for checking the suitability of mortgage lending.
• Low Interest rates are not encouraging spending. The economic downturn is so serious, US consumer spending fell at an annual rate of 3%. This is a serious decline. Even in the recession of 2001, consumer spending didn't fall. The US, like Japan in the 90s, could see a liquidity trap - where lower interest rates fail to encourage people to spend.
• The pain of falling house prices will take a long time to be removed from national psyche.
  
• The problem was not that interest rates were cut to 1%. The problem is that they stayed at 1% for too long. Of course, it is easy in hindsight to say this. But, the Federal Reserve and Bank of England will need to be more careful in avoiding the same mistake. Also, the Federal Reserve and Bank of England need to give greater weighting to asset prices and not just focus on inflation.

Boom and Busts are inevitable in some form. However, there are definite lessons we can learn from the past decade which will help minimise the risk of future booms and busts. At the moment, the economic downturn is so serious, the idea of economic boom seems hard to grasp. But, when the economy recovers in 2009 and 2010, it is essential that policy makers learn from the mistakes of the past decade. This is not just for monetary policy but also regulation of the financial system.

• What Went Wrong With US Economy

With US interest rates being cut to 1%, many are asking how low UK interest rates could go. Looking at the economic statistics, there is an overwhelming case for lower rates. These are some of the factors the MPC will be looking at when considering rate cuts.

1. Inflation forecast to Fall.

• Lower oil and petrol prices will reduce the cost push inflation factors that have caused current inflation to be high. The recession will cause a big fall in demand pull inflation factors as firms cut prices to retain custom.
• Wage restraint. The UK Labour market is increasingly flexible and wage restraint has meant real wages have shown their slowest growth for a while.
• Inflation expectations have fallen. The current inflation of 5% has not cause inflation to become ingrained in people's expectations. Lower inflation expectations make low inflation more likely. The below graph shows people's expectations of inflation have fallen.

2. Business Confidence has evaporated

Business confidence has fallen throughout the year. The levels of business pessimism are at very high levels. From Jan to Oct, business pessimism has fallen from -16 to -60

This pessimism is reflected in levels of employment which are falling sharply. Some point out that the rise in unemployment is being masked by many eastern European workers leaving the economy and returning to Poland / Czech e.t.c.

3. Credit Crunch Affecting Business.

We have heard a lot about the credit crunch making mortgages more expensive and difficult to get. But, the lack of lending is now starting to constrain business investment decisions. This will affect growth in the next 12-24 months. Business investment relies on borrowing from banks. But, the state of banks means they are reluctant to lend. Lower rates, will facilitate normal borrowing.

4. Falling House Prices.

Falling House prices creates a powerful negative wealth effect reducing consumer spending and economic growth. The government is increasingly concerned about negative equity which is a real problem in a period of rising home repossessions. See: problems of UK Housing Market

5. Official recession and Rising Unemployment

The economic slowdown has been remarkably swift, as this graph shows
Unemployment often lags behind an economic slowdown, but, it is rising fast

One of the curious features of the last couple of months is the unexpected strength of the US Dollar against a basket of currencies. This includes the currencies of emerging economies, but the dollar has also been strong against currencies such as the Euro, Pound Sterling, Canadian Dollar and the Australian Dollar. The reasons for the dollar's rise are briefly

• Lack of confidence in other countries.
• Economic slowdown has spread from US to Eurozone area - leading to lower European interest rates.
• Financial crisis has spread to other emerging economies. Investors are even more nervous about these economies than the US financial system.
  
• There has been a strong demand for dollar as hedge funds have been withdrawing their capital from oversees market, and putting it into the relative 'security' of the dollar.

With US interest rates cut to 1% yesterday, the strength of the dollar is likely to prove temporary. Indeed many commentators suggest with an increase in the US Money supply, to finance a growing national debt, the dollar looks like a bubble ready to burst.

Nevertheless this is the Impact of A Strong Dollar on Global Economy

• US exports become more expensive. With a global slowdown, US exporters are likely to experience very difficult conditions pushing economy further into recession.
• Makes Imports cheaper. Imports to America play an important role in the global economy. A stronger dollar increases the purchasing power of American consumers and leads to higher exports. However, cheaper imports may not be sufficient to boost spending. With confidence at an all time low, American consumers are more likely to try and boost their saving rates, rather than buy more imports.
• Strong Dollar will worsen the US Current Account. At around 5%, this will mean the US will need to attract more capital inflows to finance its trade deficit. However, with US interest rates at 1%, and the credit worthiness of the US being openly questioned, it is going to be difficult for the US to attract any more capital flows. This is another reason why the dollar's strength appears rather illusory.
• Good for Global exporters to US. UK firms who export to US may benefit from strong dollar, but, the exchange rate benefits may be outweighed by the global downturn.

Normally, a strong exchange rate reflects a strong economy. If the economy is in good shape - high growth, low current account deficit, low borrowing, an economy can deal with a strong exchange rate and prosper.

However, given the perilous nature of the US economic situation, the strong dollar doesn't really help them at all. The Strong dollar reflects a misplaced hope that the dollar offers security in the credit crunch. But, with the fundamental problems in US, the strong dollar will only worsen the US Economic downturn.

The Bank of England has warned that 1 in 10 householders (1.2 million) face the prospect of negative equity (house value is less than the outstanding mortgage debt). As house prices fall in 2009, the number facing negative equity will increase.

Why Negative Equity Has Occured.

• Falling House prices House prices have fallen 15% on their mid 2007 peak. House prices are falling because:

1. Shortage of available mortgages due to credit crunch.
2. Poor affordability ratio of house prices to incomes is still high (above long term trend)
3. Lack of Confidence in housing market. No one wants to buy when house prices are falling
4. Impending recession and rising unemployment discourage people buying
5. Interest rates although low by historical standards, increased between 2005-07 making mortgages more expensive.
   

• Small Deposits In 2006-07, many were buying houses with small deposits. This makes it easier to slip into negative equity. For example, if you bought a house for £100,000 and only put down a deposit of 5% (£5,000) It only takes a 6% fall in house prices to cause negative equity.

How Bad is Negative Equity?

• Negative equity is not a problem if you are happy to live in the house and don't have to sell. Negative equity might not be a problem if you want to sell and move to a smaller house.
• Negative equity means it is much more difficult to remortgage. The fall in house prices creates a negative wealth effect and lowers consumer confidence. This reduces consumer spending and is a factor causing the current recession. - See: effects of lower house prices.
  
• Negative equity is a real problem if you fall into mortgage arrears and the home is repossessed. This means that even after selling the house, you will still owe money.
• Unfortunately, repossessions in the UK are rising at the moment. Repossessions in the last quarter increased to over 11,000 in the last quarter. This is a 70% increase on this time last year.
• It is worth pointing out that the ratio of home repossessions is still relatively low (about 0.4% of all loans). This is lower than the rate of repossessions in the last boom (peaking at 75,000 or 0.77% of loans. (Mortgage default rates in UK) Nevertheless, home repossession is one of the most stressful financial experiences. With unemployment rising, repossessions are forecast to rise in the near future.

Prospects for UK Housing Market in 2009

There are tentative signs of slight easing in interbank lending following the government's bailout for the banks. However, there is going to be no quick return to the lax lending criteria of the 2000s. Mortgage lending will remain constrained next year.
With a shortage of mortgage and rising unemployment demand for houses will remain muted. Futhermore no one wants to buy in a period of falling house prices.

Any Good News for Housing Market?

The best news for the housing market is the recent cut in interest rates from 5.0% to 4.5%. We can also expect future interest rate cuts to under 3%. Lower interest rates will make mortgages more affordable and avoid some repossessions.

However, lower rates are unlikely cause a quick stabilisation in house prices. Market fundamentals are likely to push house prices lower, despite cheaper mortgages.
Also even lower rates may be insufficient to avoid a rise in repossessions as the rate of unemployment rises sharply

A feature of the current financial crisis is how hard it has hit supposedly 'strong / safe economies' like the US, UK, Europe e.t.c. However, now attention is switching to emerging economies and the potential problems they are facing.

Problems Facing Emerging Economies.

Large Current Account deficits.

Iceland had a current account deficit of 7% of GDP. South Africa has a current account deficit of 7.7%. Basically, this means they are importing more goods and services than exporting. To finance this current account deficit, it is necessary to attract capital inflows (either hot money flows or long term capital investment e.g. Foreign firms investing in India.)

The problem is that the credit crunch has made it more difficult to attract sufficient capital flows. Even Russia, which has a current account surplus requires capital flows, but, they are now struggling to attract sufficient funds.

If a country cannot finance its current account deficit. A depreciation becomes almost inevitable. This was one reason for the depreciation of the Icelandic Krona. It is why the South African Rand and Hungarian Florint are depreciating.

Depreciating Exchange Rates

A depreciation in the exchange rate does make exports cheaper. But, it also makes imports more expensive and the repayment of foreign debt more difficult. When a currency depreciates, a country struggles to repay its external debt and therefore investors lose confidence in the economy causing a further depreciation. - It is a vicious circle. Also a depreciation in one currency can have an endemic effect on nearby economies. E.g. depreciation in Thai Bhat in 1998 precipitated a wave of falling currencies it become known as the Asian Crisis of 1998. The concern is that a depreciating Hungarian Florint could spark a wave of speculative selling for nearby Eastern European currencies.

Confidence.

In economics we keep coming back to this issue of confidence. In the financial sector, confidence is everything. The problem is that as emerging economies face difficulties investors give bad credit ratings to these economies. Because there is a deterioration in the credit worthiness of the economies, they are forced to increase interest rates to

• Protect their currency
• Encourage people to buy their now 'risky' government bonds.

Hungary recently had to increase interest rates 3% to 11%. Higher interest rates are very damaging for the economy causing lower growth. (Just imagine if the UK had to increase interest rates 3% at the moment?)

Borrowing.

Many Hungarians took out loans and mortgages in Swiss Francs. This seemed attractive because Swiss interest rates were lower. However, now the Hungarian Florint is depreciating, loan repayments are increasingly drastically.

Government Borrowing

High levels of government borrowing mean interest rates may need to be higher. It is also a particular problem if the government finances its debt by selling to other countries.

Basically, emerging economies have many similar problems to UK and US, they have borrowed too much and overextended themselves. The problem they face is that there governments may have less resources to intervene and guarantee the banking system. It may require concerted international action to intervene.

• Financial Crisis explained
  
• A New Set of Financial skittles ready to fall - Anatole Kaletsky at Times
• How Emerging economies are suffering at Economist

• This graph of economic growth shows how quickly the UK economy has deteriorated. It explains why the MPC cut interest rates by 0.5%. It also explains why many are calling for future interest rates cuts. Some forecast interest rates could fall to as low as 1%.
  
• With UK interest rates forecast to fall significantly, the value of the Pound since the summer has fallen by nearly 25% against the dollar.
  
• Lower UK interest rates mean it is less attractive to save in the UK, reducing demand for Pound Sterling
  
• Another reason for the strength of the dollar against the Pound, is the growing uncertainty of emerging economies. Hedge funds and investment trusts have been selling their investments. Since most of these hedge funds and investment trusts are based in dollars, there has been a rise in demand for dollars. This explains some of the recent strength in the dollar.

Video on Pound Sterling

• How much should interest rates fall?
• Understanding exchange rates

Since the Bank of England was made independent in 1997, there has been a general consensus that they did a good job in preventing boom and bust and promoting the longest period of economic expansion on record. (1992-2008) Gordon Brown rarely missed an opportunity to offer himself self-congratulations on giving the Bank independence and therefore, avoiding the boom and bust, which characterised the post war British economy (See: Lawson Boom) However, the speed at which the UK has entered recession this year have left many re-evaluating the performance of the Bank.

Positive Aspects of the Bank's Record

• We did have 16 years of positive economic growth. (compared to two recessions in the space of 10 years 1981 and 1991).
• The Bank did avoid an inflationary boom. Inflation only increased above target this year, and that was due to cost push factors beyond the Bank's control.
• The recession has been caused not so much by UK monetary policy, but, the subprime mortgage crisis, originating in the US.

Nevertheless, UK policy has arguably failings.

1. Problem of Inflation Targeting. The Bank of England have one target - low inflation.- CPI of 2% +/- 1. The problem with targeting just inflation is that the Bank have a duty to place much less emphasis on:

• Slowing growth
• Booming housing markets and assets

For example, 2008, has presented the Bank of England with a dilemma - because of cost push factors (rising oil prices) we had a rise in inflation and lower growth. Because inflation rose above target, the Bank didn't want to cut rates (until this October). As David Blanchflower, a member of the MPC, argued, this meant interest rates were too high for too long. Meaning that the recession will be deeper. If the Bank had a target of low inflation and high growth, they may have had greater confidence to cut rates sooner and help avoid recession.

Should the MPC have prevented Booming house prices?

The other aspect is that maybe the MPC should have used interest rates to reduce the growth in house prices. If a boom in house prices had been avoided, the slump would have been less severe.

However, I am not convinced they should have used interest rates to target house prices. The boom and bust in house prices was due to:

• Shortage of supply, squeezing prices higher then lower
• Mortgage lending. Once very generous then completely seized up.

To avoid boom and bust in the housing market, we need policys specifically for housing market, rather than relying on macro instruments.

What Should Happen Now?

There is a good argument the MPC should give greater flexibility in targeting macro economic objectives.

• Low inflation is important, but, it is obviously not the only macro economic objective. Inflation is above target, but, clearly the prospect of unemployment rising to 3 million should be taken into consideration rather than just worrying over temporary cost push inflation of 5%.
• The government actually state the Role of the MPC is:
• The objectives of the Bank of England shall be
  a) to maintain price stability
  b) subject to that, to support the economic policy of Her Majesty’s Government,
  including its objectives for growth and employment.”
• The MPC could be given flexibility to consider other issues such as house prices / unemployment and balance of payments.

Should Government Take away Independence and control Interest Rates?

I don't think so. I don't believe if the government had been controlling interest rates in the past decade we would be any better off. The government certainly wouldn't have raised interest rates to avoid a boom in house prices. However, the government can change the MPC
s Target - including growth as well as inflation.

• An Evaluation of the MPC in controlling inflation

Alan Greenspan admitted today, many mistakes were made during his period as Chairman of the Federal Reserve. Greenspan was once hailed as an economic genius who presided over a long period of economic stability. But, now many blame him for fostering an asset boom and bust.

In a remarkable admission, he states how much he underestimated the capacity for banks to take reckless decisions.

"Those of us who have looked to the self-interest of lending institutions to protect shareholder's equity – myself especially – are in a state of shocked disbelief."

In particular Greenspan is criticised for making two mistakes.

1. Keeping interest rates too low in the early 2000s. This caused a boom in demand for houses and encouraged people to take out a mortgage who wouldn't have been able to afford it at normal interest rates. When Greenspan finally had to increase interest rates in 2005, the shock caused many to default.
2. Not Have greater Regulation of Subprime Mortgages and Financial sector. Arguably, Greenspan had the authority to insist on greater regulation of subprime mortgages and financial derivatives. This would have prevented the series of bad loans and unacceptable risks taken by banks.
   

Greenspan admitted that they had poor information about the standards of mortgage lending.

"We didn't know that a deterioration in standards was occurring until 2005. The real toxic mortgages occurred with the increase in securitisation and the huge demand from abroad, and to the extent that Fannie and Freddie were involved, from them as well."

Of course, it is easy to be wise after the event. Greenspan was hardly alone in rejecting calls for greater financial regulation. He was not alone in wanting to keep interest rates low to boost economic growth.

Part of the problem is that policy makers are often making decisions based on past economic and financial trends. For example:

• A Housing market boom and bust has never effected the real economy so much before. Policy makers used to feel targeting inflation was enough.
• There was a widespread ignorance or willingness to turn a blind eye to the shocking practises of subprime mortgage lending.
• Part of the problem was also that the government regulated, Freddie Mac and Fannie Mae were told to make mortgage lending as widely available as possible.

Related

• Boom and Bust in US Housing Market
• What Went Wrong with US Economy
  

Readers Question: In an article on the BBC website http://news.bbc.co.uk/1/hi/magazine/7682887.stm John Sloman quoted this: ‘The long run is a misleading guide to current affairs - in the long run we are all dead ‘ JM Keynes

I thought this was very interesting as it puts forward the idea that we shouldn’t bother to think beyond our own lifetime, our own generation. Which I think is a terrible mistake.

This quote came from Keynes' General Theory of Money. During the Great Depression, the prevailing economic orthodoxy was the Classical view. This stated that markets would adjust to disequilibrium without government intervention. Therefore, when the Great Depression occurred in 1930, the classical response was to do nothing - because in the long run the markets would solve the problem (real wages would fall, people would return to work and the economy would return to full employment)

However, Keynes said this was madness - In the depth of a recession, why not try to do something about it, rather than leave to 'market forces'. Yes in the long run, the recession may end, but, here the long run could be 10 years. Keynes wanted to try and solve the depression now rather than wait for 10 15 years or however, long the 'longrun' was.

In particular Keynes criticised the idea that falling real wages would solve unemployment. He argued falling real wages would just leave people with less money and therefore aggregate demand would fall more. Keynes argued for public works schemes, financed by government borrowing to inject money into the economy and get people back to work and spending. This was too radical for the UK Treasury, and generally the UK didn't follow Keynesian policies in the Great Depression. If we had injected government spending, the recession may have been less serious and ended sooner.

See also: Keynesian Economics back in fashion

Readers Question: In recession it is good to cut interest rate, but to how far should interest rate be cut? What are the disadvantages of cutting interest rate?

It's a good question, and the MPC will be having a big debate amongst themselves how much interest rates should fall. For the past year, David Blanchflower has been arguing interest rates are too high and need to come down more quickly. However, his other colleagues were more cautious, so interest rates have fallen only slowly this year. In the US, interest rates have fallen much more quickly to 2%

Lower interest rates help the economy to recover from recession because:

1. Reduces mortgage payments, increasing disposable income. (Just yesterday I had a letter from Standard Life, saying my interest only mortgage will fall from £627 to £570 a month - I will definitely be spending more!)
2. Cheaper to Borrow for investment
3. Less incentive to save, more incentive to spend.
   
4. Reduces value of Pound, which makes exports cheaper and helps increase aggregate demand.
   

With economic prospects plunging, unemployment rising and manufacturing output falling, there are some people arguing that rates should fall to 2% soon.

What are the disadvantages of Interest rate cuts? - Why are Interest rates not 2% already?

1. Inflation. Lower interest rates typically boost spending and cause inflation. It is the prospect of more inflation which make the MPC reluctant to cut rates. Unfortunately, this year we have seen a rise in inflation to over 5%. This is because of cost push factors, such as rising oil and electricity prices. The MPC have an inflation target of 2%, so in theory normally, they would be considering increasing rates. However, with unemployment approaching 2 million, inflation doesn't seem very important in comparison. Also there is a hope that this inflation will prove only temporary and next year inflation will fall sharply.

2. Savers Lose Out. Interest rate cuts are great for people like me with large debts. But, interest rate cuts are not good for pensioners who live off interest on savings. At the moment, inflation is higher than base rates. Therefore, many savers may see a decline in the real value of their savings. Cutting interest rates to 2% would make them worse off, especially if inflation persists. Savers are often pensioners.

3. More Expensive Imports. Since interest rates have fallen, the value of the £ has fallen. This is due to less 'hot money flows' people wanting to save in the UK. Because the value of the Pound is lower, imports become more expensive. This reduces our living standards and can contribute to imported inflation. (though lower exchange rate is good for exporters)

4. Lower Interest rates may not work. This is a kind of disadvantage. Lower interest rates may not avoid recession. Lower interest rates may not help because:

• Banks don't want to lend. Therefore, even though borrowing costs are cheap, the finance isn't there because of the credit crunch.
• Banks may not pass the base rate cut onto consumers
• Confidence is low therefore people don't spend any more, even though mortgages are cheaper. (e.g. liquidity trap that Japan faced in the 1990s.)

• An Evaluation of the MPC in cutting interest rates
• How the MPC set interest rates
  

Question on National Debt.

Many readers are asking about the true value of National Debt as some commentators are suggesting the real value of national debt is closer to £2 trillion rather than the official figure of £613 billion.

See: Readers Question: What is true level of government borrowing?

Basically, I tried to use an analogy. if you have a loan of £10,000 and in 10 years, you knew you had to pay £7,000 for your children's education - would you include this spending commitment in your level of debt?

Also, if you acted as guarantor for your child's mortgage of £50,000, would you consider your level of debt to be £10,000 or £60,000?

(I know It's not a perfect analogy, but it helps to give a perspective we can more easily relate to)

• National Debt
• Problems of National Debt Statistics
• Who has the highest National Debt? List of countries.
  

The Bank of England admitted for first time, the UK was on the brink of a prolonged recession.
Manufacturers recently reported their bleakest outlook since the 1980 recession.
The pound fell in anticipation of future rate cuts. Many now expect another half point rate cut in November. This is good news for borrowers, but, bad news for savers who will see a bigger fall in the real interest rate.

Manufacturers will see a crumb of comfort in the fact the Pound fell to a five year low, in anticipation of rate cuts. The depreciation in the Pound makes exports more competitive. But, even this may be insufficient to prevent a fall in demand for exports due to the global slowdown.

Pound tumbles on King Warning of recession at Times

Can A recession be avoided?

Readers Question: I’m just curious about how and why the dollar has strengthened (at least against the Euro and Pound) and why the US would benefit from a stronger USD.

Quite a few people have been asking me why the dollar has been stronger in the past few months. The last time I wrote why the dollar was stronger, it promptly fell by 5%, so let's see what happens this week. :)

USD to Euro Exchange Rate

• US Dollar to Euro. The US Dollar has appreciated from US $1.6 to 1 Euro to US $ 1.32 Euros.
• Against the £ the Dollar has appreciated from US $ 2.0 to £1 to US $ 1.74.

This appreciation of the dollar doesn't represent a changing of the fortunes of the US economy. Economic fundamentals still point to a weak dollar.

1. Current Account deficit
2. Slowing economy and prospects of even lower US deficit.
3. Growing National Debt, which could lead to inflationary pressure.
   
4. US relies on foreign countries to buy about 25% of its National debt. This makes the US vulnerable to China and Japan withdrawing their demand for dollars.
   

See: Why US Dollar is falling. Although written over a year ago, it is still relevant today.
The real worry is that the US becomes so indebted the Federal reserve start to default on the US National Debt, this would cause a run on the dollar. See: Will the US Dollar Collapse

So Why is the Dollar Stronger?

There is a pretty convincing case to say the dollar should be falling. But

1. The dollar has been in along bear market. In the beginning of 2002, the exchange rate was US $ 0.9 / 1 Euro.

1. The recent strength of the dollar should be placed in a longer context. Yes, it has appreciated a little, but, over the past few years, it is has still fallen in value.
2. The Euro and UK economy have deteriorated sharply in the past few months. The strength of the dollar really means the weakness of the UK and Euro economy. The US was the first economy to experience an economic downturn. But, the UK and Euro economies have faced a sharp slowdown in the past few months. This has led to interest rate cuts in UK and Europe. Also investors expect further interest rate cuts in Eurozone and UK because of the impending recession. Interest rates are currently higher in Europe than US, but, people expect European interest rates to fall.
   
3. Purchasing power parity. The US dollar is cheap on purchasing power parity. Europeans going to America find goods to be very cheap.
4. Hedge Funds. Problems in emerging markets are encouraging people to withdraw assets from these countries. Therefore, as these are being sold people are exchanging them for dollars.
   

Is Stronger Dollar A Good Thing?

A strong dollar makes imports cheaper. It reduces inflation and it leads to higher living standards. But, a strong dollar causes less exports. A strong dollar is good during a boom, but, in a recession it can cause slower growth.

Is A Strong Dollar a Good thing?

• Boom and Bust in Housing Market
• Boom and Bust in Stock Market
• Too much bad Lending and Defaulted Debts held by banks
• Economic Growth Ground to a Halt

Sound familiar?

Actually, this time we are not discussing the current UK / US financial crisis, but, the Japanese crisis which began in 1990 and led to a 'lost decade' - over 10 years of a stagnating economy. On the one hand it is foreboding for what could happen in the West. On the other hand, it could be instructive for what we need to avoid.

Why Japan Experienced Economic Crisis.

1. Late 1980s, excess liquidity in the financial system caused an asset and stockmarket bubble. People with spare cash bought assets and shares causing them to rise. However, in the last 1980s, the Japanese monetary authorities were worried about inflation and so doubled interest rates. They were then slow to reduce them.
2. This caused a fall in house and share prices, which lasted 10 years. It is one of the longest bear markets on record.
3. Higher interest rates and slumping asset values caused an increase in loan defaults.
4. Loan defaults were compounded because Japanese banks had made a series of bad lending decisions.
5. The Japanese economic miracle was based on a strong degree of government intervention. IN some respects this worked very well. But, the downside is that the government tried to protect declining, inefficient industries / firms.
6. When the crisis came, banks were encouraged to continue lending to firms, even if on verge of bankruptcy. In other words, the decision to bailout declining / inefficient firms masked the problem but didn't deal with the underlying issues.
7. There was a failure to acknowledge the true extent of the problem, hoping asset prices would rebound (they didn't)
8. Inflation expectations fell to negative. Deflation made normal demand side policies ineffective.
   

Government / Monetary Authority Response

• Cut interest rates to 0%
• Increased government spending to try and increase aggregate demand.
• There was a reluctance to increase money supply, because even when Japan had deflation, they held an unwarranted fear of inflation.
• It was not until 2005, that Japan finally managed to have positive inflation expectations through quantitive easing. This led to first periods of real positive growth.
  

However, these demand side policies failed to stimulate the economy. Because

• Deflation. With prices falling, people wanted to delay buying. Even 0% interest rates were sufficient to encourage consumers to spend. It was a classic liquidity trap. Deflation also increased the real burden of debt increasing problems for firms, consumers and banks.
• Government spending poorly targeted.
• Falling asset prices caused a powerful negative equity effect.

Economic Consequences of Japan's Economic Crisis

• Long Period of stagnant Growth
• Rise in Unemployment. Unemployment was almost unheard of in the post war period. The official figure suggests unemployment of 5%. But, this hides a lot of disguised unemployment.
• Rise in inequality. Issues such as homelessness have become a real problem.
• National Debt has risen to 180% of GDP.

What Can We Learn from Japanese Crisis?

• Cutting interest rates and higher government spending are not guaranteed to kickstart an economy if structural problems remain.
• Asset booms and busts can be very destabilising. But, people and governments tend to ignore them. It is easy to convince ourselves in our case it is not a bubble.
• Government support for ailing firms often only prolongs the agony.

• Asian Financial Crisis 1990s
  
• Addressing financial crisis in Japan
• What Can we learn from Japanese financial crisis?
  

At least someone is benefiting from the credit crunch. Apparantely, books on the credit crunch are flying off the shelves. Book companies are offering big contracts to sign up a variety of offers. With the credit crunch developing all the time, 2009, is likely to see more books hit the bookshelves. In the meantime, these are some of the best selling books on the current credit crisis.



The Credit Crunch: Housing Bubbles, Globalisation and the Worldwide Economic Crisis
by Graham Turner - A Critique of the free market policies which created unsustainable booms.



The Crunch: The Scandal of Northern Rock and the Escalating Credit Crisis (Paperback)



The Credit Crisis by George Soros. - George Soros explains the 2008 credit crisis from his point of view.



Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash by Charles R Morris



The Subprime Solution: How Today's Global Financial Crisis Happened, and What to Do About It by R.Shiller

• Credit Crunch Explained
• Essays on Credit Crunch
  

• Books on Financial Crisis at Amazon.co.uk
• Books on Credit Crunch at Amazon.com

After decades of Monetarism and free market liberalism, it seems 'Keynesian economics' is coming back into fashion.

The term 'Keynesian economics' is a loose one. But, basically involves more government intervention, such as spending more in a recession to try and stimulate the economy. In particular, Keynes was an advocate of greater public spending during a time of recession.

In a recent post, I suggested the government need to increase public spending to avoid the worst of a recession and prevent unemployment rising too much.

Darling said yesterday:

"Much of what Keynes wrote still makes sense. You will see us switching our spending priorities to areas that make a difference - housing and energy are classic examples where people are feeling squeezed. What I want to avoid is getting ourselves in a position governments have done in the past, where you face an immediate problem and cut back on the things the country will need in the future ... we can allow borrowing to rise,"

It was also noted that UK public sector debt is much lower than many of our competitors, giving us room for expansionary fiscal policy. (of course, we could have had more room if the government had been more prudent in the boom years.

It remains to be seen whether we can spend ourselves out of a recession. But, at least it might mitigate some of the effects. The effectiveness of the spending will depend on:

• What is the public spending targeted on?
• Does the spending help to increase productivity e.g. education, transport links can help increase productivity and enable low inflation growth.
• How Bad is the rest of the economy? If banking troubles persist, no amount of injections may be sufficient to overcome the black hole in the economy.

Mr. McCain was asked in one of the debates how he would deal with the economic crisis, he answered: “Well, the first thing we have to do is get spending under control.”

In a deep and protracted recession, the last thing you want to do is cut government spending. Reducing government spending will reduce aggregate demand and slow the economy even more. By the way this is exactly what the British government did in 1930. When faced with an economic slump orthodox economic response was to balance the budget. So the government actually cut unemployment benefits and public spending. Needless to say, it made the recession much worse causing further falls in GDP. (see: causes of Great Depression)

With evidence of a serious recession: (and evidence is compelling)

• Retail sales falling
• Unemployment rising
• Manufacturing output falling
• Confidence very low
• Investment levels falling
  
• House prices falling
• (To say nothing of all the financial woes)

Fiscal Policy

One of the best ways to stimulate the economy is through public spending on targeted investment projects.

Fiscal policy has many limitations, but, it is more effective than a cut in interest rates. Lower interest rates will have little effect when confidence is so low.

National Debt.

It is true that expansionary fiscal policy will increase government borrowing - already high (National Debt). But, this spending and borrowing is temporary. When the economy recovers, the government should reduce the deficit. The problem is that the government increased spending and borrowing in the boom years. They shouldn't have done this. But, just because they did the wrong thing, doesn't mean we should refuse to increase spending when we actually need it.

Yes, UK National debt will increase, but, if we stay in a protracted recession it will increase anyway.

Yesterday, I was buying a Ryanair Ticket to Frankfurt, and was surprised at how many different ways they try to make the ticket price more expensive. It makes interesting economics.

From: Leeds to Alicante on 22nd and 24rd Nov

• the cost of the Air fares was £0.00

Taxes and Fees were £46.41. This involves:

• 37.67 GBP Tax and Fees
• 8.74 GBP Insurance/Wheelchair Levy/Aviation Insurance

Airport Taxes

As an economist, I actually don't mind paying airport taxes. Flying has a significant negative externality of greater air pollution and contribution to global warming. The tax makes people pay the social cost of flying. They also raise revenue for the government. If the government were to abolish taxes on flights, it would simply require higher taxes elsewhere. (see: 10 Reasons not to cut petrol tax)

Extra Fees for Ryanair

• Checking in One Bag - £24. Extra luggage does incur a marginal cost of more fuel needed for heavier weight of plane and increased time involved in check in. This is important for Ryanair which rely on quick turnovers. But, I'm sure the cost is not £24. By the way, if you wanted to take a sports bag. The cost will be £50.
• Priority Boarding Be First Passenger - £8.00. This is an interesting ploy. For £8 you can check in quicker and spend more time in duty free and cafes. It is a classic case of price discrimination. It is a way to find passengers who don't mind paying more. Some customers may think £8.00 is not very much so they will pay, even though the benefit is relatively small. For customers whose demand is elastic (sensitive to price changes), they will not pay. Ryanair will definitely profit from this scheme. Overall customers don't get to fly any quicker, it just means some can pay for the privilege to 'jump the queue.' This has been labelled 'Perkonomics' charging customers to get fringe benefits. - see article in Independent
  

• People may say it is unfair, but on the other hand you could argue by charging rich customers an extra £8, they are effectively subsidising lower fares for poor people. If they couldn't gain £8 surplus payments from people willing to pay, the basic ticket price wouldn't be £0.

• Insurance - £7.37 Unless you only fly once a year, it nearly always makes sense to get insurance for a whole year. You can get an annual insurance policy for £40 or less. Buying insurance per flight is a very expensive way to get insurance.
  

• Credit Card charge £8.00 This is a cheeky way to get more money out of you. When you are all ready to pay, you realise whatever method of payment you make there is a charge of £8.00. Even when I choose debit card they wanted to charge £8.00. This is bad because the cost to them is much lower. Debit card charge is no more than 50p. A Credit card is about 2% of price. So they are definitely charging more than the cost. But, when you've got all the way to the end, who is going to pull out because of an additional £8.00 charge? If you knew at the start you had to pay and £8.00 some may not buy. So leaving this charge to the end is clever.
  

Total Cost of Ryanair

• Air Fares = £0.00
• Taxes and Fees = £46.41
• One Bag = £24.
• Priority boarding = £8.00
• Insurance £7.37
• Credit Card Charge = £8.00
• Total = £93.78

Other ways to make money for Ryanair - Selling food, drinks, lottery tickets.

It's like the old adage of a cinema who offer cheap tickets so they can make profit selling popcorn and cola. Ryanair offer 'free flights' because they make so much money charging for extras.

Yesterday, Britain experienced the quickest rise in unemployment since the last recession, 17 years ago. Statistics from the International Labour Organisation showed a rise in unemployment to 1.69 million (an increase of 164,000 in the 3 months to August). The Government's claimant count is 978,000. Over the coming months, unemployment is liable to rise to well over 2 million and could reach 3 million the rate of unemployment in the last 2 recessions.

Brief History of Unemployment in UK

Source: Dept for Work and Transport

After the ravages of the Great Depression era where unemployment was over 25%, unemployment in the UK remained relatively low from 1945 until the late 1970s. When Beveridge introduced the Welfare State in 1945, one thing he mentioned was the necessity of maintaining full employment. Using demand management policies and benefiting from a boom in global trade, the UK more or less achieved full employment, until the 1970s. In the 1970s, rising oil prices caused stagflation and unemployment began to rise but was still relatively low.

It was in the manufacturing recession of 1981 when unemployment rose to unprecedented levels. Not only did unemployment reach 3 million, but, it remained stubbornly high until 1986 well into the economic recovery. The huge rise in unemployment was due to the strong value of the Pound, high interest rates and the deflationary impact of strict Monetarist policies. In particular, it was the manufacturing sector that suffered. Male full time, unskilled labour was particularly affected.

Unemployment remained high throughout the 1980s. Even at the peak of the boom in 1989, 1.6 million people were unemployed. This figure involved high rates of structural unemployment (also known as the natural rate of unemployment). This structural unemployment was because the recession of 1981 had made many unskilled workers unemployed. In the fast changing workplace, these former coal miners and ship builders struggled to get work in the new economy. Geographical unemployment was also a strong feature of the 1980s. Former areas of manufacturing and mining, struggled to cope with the large scale redundancies.

In 1991, unemployment rose again, as the economy slipped into another recession. Unemployment peaked in 1993 at just under 3 million. Unlike the 1980s, unemployment fell quicker. From the mid 1990s to 2008, UK unemployment was relatively low. Looking at official statistics, unemployment was fairly close to full employment at just over 3%.

This shows that unemployment is highly cyclical. When the economy goes into recession, unemployment typically has increased to 3 million. If the recession of 2009 is deep, we can expect unemployment to get to 3 million.

Low unemployment was due to:

• Long period of economic growth
  
• Disguised unemployment, many unemployed were allowed to take sickness and disability benefits. Therefore, they are not counted as unemployed. See also: What is True Level of Unemployment?
  
• The Labour Force survey has consistently been higher than the government record of people on Job seekers allowance. This reflects the fact it is very difficult to get benefits these days. Some unemployed are not eligible for benefits for a variety of reasons.

• Regional Recovery. Former depressed areas like South Wales and the North East have been relatively successful in finding new industries to replace the old heavy manufacturing.
• New Deal. Better education and training for the unemployed to get back to work.

Why Unemployment is set to Rise in UK

• Contraction of Credit. Credit crunch has made banks reluctant to lend loans, mortgages and credit. The impact is a reduction in consumer spending, lower investment and lower economic growth. Big investment projects are being delayed until lending becomes easier.
• Global Downturn. The global economy is slowing down, leading to lower exports and international trade.
• Sectors. Certain sectors have been particularly badly hit by the financial crisis, estate agents, banks, construction industry. There will be increasingly a knock on effect to the rest of the economy.

Other essays:

• Is Unemployment a price worth paying for low inflation?
• Types of Unemployment
  

Bonus Joke: "Why didn't the little boy get any pocket money? Cos his mum's gone to Iceland." - sorry :)

• The National Debt refers to the amount the government owe the private sector. The Office of National Statistics state that at the end of August 2008, public sector debt stood at £637.4 billion. (or 43% of National GDP). This includes the £87bn Northern Rock nationalisation.
• With this precedent, it is likely the office of National statistics will include, at least some aspects, of the Government's bailout package as a government liability.
• If the whole £500bn rescue package were to become a contingent liability and put on the public accounts, that would push public sector debt to over 100% of GDP. It is certainly a striking figure. However, this extra £450bn is a different kind of debt.
• So far the government has spent an extra £37bn in buying shares in major banks. This will directly increase public sector borrowing. The government will have to borrow more and sell more bonds and gilts. However, the other £450bn doesn't necessarily imply government's will have to spend more.
• There is £250bn which is to act as a guarantee for bank lending. It will only actually cost the taxpayer if banks default (which is unlikely at the moment)
• Another £200bn of taxpayers money is to be swapped for bank assets such as secure mortgages and loans. The special liquidity scheme is unlikely to cost the taxpayer anything.

Underlying Public Sector Debt.

Even if we don't include the government guarantees for bank loans and the special liquidity scheme. The underlying trend is for government borrowing to rise.

Forecasts For National Debt

Unfortunately, short term and long term factors both point to increasing government borrowing. In the short term public borrowing will rise because:

• Recession - leads to lower tax revenues and higher government spending on unemployment benefits.
• Buying shares in leading banks (£37bn so far)

In the long term public sector borrowing is forecast to rise because:

• Ageing population. Old people need more pensions and health care. Less young people to pay tax.

• UK National Debt
• Should We worry about national Debt?
• How is National Debt financed?
  

Amidst all the talk of impending recession and possible bank collapse, an inflation rate above the government's target seems of minor significance. Yet, the news that CPI inflation increased from 4.7% to 5.2% will offer no encouragement to the MPC and government.

• The main cause of the inflation is rising gas and electricity prices. Gas prices rose nearly 50% from 12 months ago.
• It is bad news for pensioners who spend a large percentage of their income on heating. It is also bad news for those who rely on savings for income.
• With interest rates cut to 4.5%. It means real interest rates are negative (5.2% - 4.5%) See: Bank of England Website
  
• This means the value of savings is decreasing. Furthermore, RPI inflation which includes housing costs is even higher.
• The only good news is that inflation is forecast to fall sharply in 2009 as the economic slowdown and lower oil prices feed into inflation.
• I don't think that this spike in inflation will prevent the MPC cutting interest rates again in the near future. But, it might make them delay cutting rates, which will harm the prospects of a recovery.

Readers Questions:

I answered 2 readers question at my A Level Economic Blog

• The rate of Mortgage Defaults in the UK
• Questions on Bank Lending

Feel free to ask questions, especially on the financial crisis

European leaders and now the US have followed the UK example to take shares in struggling banks. Rather than buy bad debts, governments are taking an unprecedented stake in their major banks in an effort to recapitalise their balance sheets.

There was a time when the British Labour party was ideologically committed to nationalisation. The famous Clause IV of the Labour party constitution promised 'common ownership of the means of production' (before Tony Blair changed it - remember the days of New Labour?)

Gordon Brown has said that the government is in the business of protecting banks from going bankrupt and not in the business of running banks. The government has said that whilst the government will take part ownership, it will keep the running of banks at arms length. However, early evidence suggests that this arm may be very short indeed.

Already, the government has shown it can't resist making digs at executive pay and making the banks promise to limit the pay for banks. The government has also apparently made the banks promise to keep mortgages available to first time buyers.

These are both laudable policies, which will be popular with the general public. But, it raises the big question - is it good for governments to meddle in the running of banks and industry?

Arguments for Public Ownership.

Private Sector ignores externalities and social issues. Governments can run industries to maximise social efficiency. For example, private banks may be keen to repossess homes, a government run bank may be able to avoid home repossession. In transport, private run buses and trains ignore the positive externalities involved in public transport. The government could promote

Taxpayer can benefit from Dividends. The government is now a major shareholder in a potentially very profitable industry. The dividends can be used to reduce tax payments.

Market Failure. By pursuing short term profit maximisation, it is argued private firms may make bad decisions which harm the industry and wider economy. The banks inability to understand the risk involved in credit default swaps and speculating on the derivatives market is a good example of this irresponsible 'free market' activity.

Problems of Public Ownership.

Poor Incentives. The argument is that private firms responsible to their shareholders will try hard to maximise returns. Government owned industries invariably lack incentives to compete, innovate and maximise returns.

Government Meddling. The government struggles to resist meddling for political reasons. For example, the government may put pressure on banks to offer attractive mortgages to first time buyers because this will help the housing market. However, critics argue that the government could ignore market signals that house prices need to fall and therefore, artificially keep house prices too high; unwittingly the government could start another boom of excessive mortgage lending. Critics argue that the problem of Freddie Mac and Fannie Mae was government insistence they be willing to lend to all income groups.

• Even limiting executive pay may have its problems. Only the most foolhardy city financer would try to defend bonuses being paid to executives who lead their bank to bankruptcy. But, supposing government owned banks imposed salary caps for executives and managers. The fear is that they would then struggle to attract the best executives and therefore the performance of the bank would suffer in the long run.

Tax Payer is Liable. My hope is that the government have a good deal with buying shares in the banks. But, if things are worse than expected, the taxpayer could be liable for huge losses. This increases the national debt. Also the fact that the government won't allow banks to fail could encourage banks to lose the incentive to worry about bankruptcy.

Related

• Nationalisation of Northern Rock
• Arguments for Nationalisation
• Arguments for Privatisation

I was worried that the Nobel Committe were going to give this year's nobel prize for Economics to an economist who did work on the benefits of free, deregulated financial markets.

Thankfully, they choose not to embarass economists. Instead they gave the prize to Paul Krugman.
With his column at the New York Times and several books, he has done a lot to demystify economics and point out the failings and limitations of unbridled free markets. There are few modern economists I actually really like. But, Paul Krugman is one.

• Paul Krugman at Nobel Prize Committee
• Paul Krugman column at New York Times
• Paul Krugman at Amazon.com
  

It is easy to dismiss the economic problems of Iceland as being isolated to a small country which produces little other than cod, haddock and the odd volcanic spring. But, unfortunately, the problems which caused the collapse of the Icelandic banking system and currency are replicated in many other countries. We are also finding we have much stronger ties to Iceland than many might have realised.

Reasons for Collapse in Icelandic Economy

Current Account Deficit of over 7% of GDP.

This was indicative of the fact Iceland was importing more goods and services than it was producing. It reflected the high levels of consumer borrowing. A current account deficit of this size puts downward pressure on the currency because it is difficult to attract sufficient capital flows to pay the current account deficit.

• Current account deficit in US is over 5% of GDP (was over 6.5%) UK about 4% of GDP.

Banks Overstretched Themselves.

Following privatisation, Icelandic banks gained assets worth ($180 billion) by the end of 2007, compared with an economy of just €14.5 billion. By the end of 2006 only 30% of loans were backed by deposits. The banks were highly geared, working on tight margins - This is OK in times of fluid money markets. But, with the credit crunch, it became too difficult to raise sufficient short term finance. (The lack of deposits was a reason why Iceland banks were offering the highest interest rates. It was these high interest rates which caused city councils to put their money in) Interestingly Northern Rock failed for a very similar reason - high ratio of loans to assets (44%)

High Personal Debt

Personal Debt in Iceland reached 213% of personal disposable income. In Britain this figure is 164%. In the US, it is 140%. In Germany about 100%. The high levels of personal debt were reflected in the balance sheets of the Icelandic banks who were willing to lend with few questions asked.

High Total Debt.

As well as high personal debt, government and corporate debt mean Iceland's total debt as a percentage of GDP has ballooned to about 350% of GDP External debt now accounts for 80% of total debt. (money week - Iceland)

Inflation of 2008

A booming economy, fuelled by consumer credit caused inflation to rise to 11%. Credit growth to the private sector has exploded from 0 to near 70% year on year. In turn Iceland have had to increase interest rates, just when it will make it most painful for borrowers. At least, the UK and US have avoided this inflation and necessity for higher interest rates.

Loss of Confidence

After the government had to step in and Nationalise the third largest bank Glitnir, investors started to fear the worse. There was a flight from the Icelandic currency and investors withdrew money (Well, except the British local governments who were slow off the mark). This caused a depreciation in the exchange rate and the markets gave Icelandic National debt a worse credit rating, increasing cost of interest payments.

• The loss of confidence was not helped by the perceived bungling of the Icelandic government. E.g. the empty promise to peg the Icelandic Krona to the Euro and trying to secure a loan from Russia.

The irony is that in 2007, Iceland was ranked the 4th richest economy in the world with a GDP (PPP) of $12.144 billion and an estimated GDP per capita of$63,830. It just shows no country is immune from financial meltdown.

• Economy of Iceland at wikipedia
• Iceland Economy at Economist.com
  

How Can A few bad mortgages in the suburbs of Florida lead to the Bankruptcy of a country like Iceland? What has caused the stock market to fall by 40% -the worst decline since the Great Depression? And why has the credit crunch pushed the global economy into recession?

The Subprime Mortgage Fiasco Explained

• The Dot com bubble burst in 2001. Shares in internet companies collapsed and with events of 9/11, the US faced recession. The Federal Reserve responded by cutting interest rates to 1% - there lowest level for a long time.
• Low Interest rates encouraged people to buy a house. As house prices began to rise, mortgage companies relaxed their lending criteria and tried to capitalise on the booming property market.
• Mortgage companies actively sold mortgages to people with bad credit, low incomes - often first generation immigrants. This 'subprime market' expanded very quickly.
• Mortgage salesmen were paid on commission. Therefore, they often hid the true cost of adjustable rate mortgages and did little to check whether the homeowners could actually afford repayments in the long term. Even the feeble lending checks were ignored
• Many took out adjustable rate mortgages which were affordable for the first two years, but, then the interest rate increased making mortgage payments much more expensive.
• In 2006, inflationary pressures in the US caused interest rates to rise to 4%. Normally 4% interest rates are not particularly high. But, because many had taken out large mortgage payments, this increase made the mortgage payments unaffordable.
  
• Also many homeowners were not coming to the end of their 'introductory offers' and faced much higher interest rates. This led to an increase in mortgage defaults and companies lost money.
• As mortgage defaults increased the boom in house prices came to an end and house prices started falling.
• The falls in house prices were exacerbated by the boom in building of new homes which occurred right up until 2007. It meant that demand fell as supply was increasing causing prices to collapse, especially in suburban areas.
• The Fall in house prices made the mortgage defaults more costly. If house prices are rising and someone defaults, the mortgage company can get most of the loan back by selling the house. But, now with falling house prices, they may end up with only a fraction of the house value.
  

The Role of Credit Default Swaps

You might imagine that this irresponsible lending by US mortgage companies would mean they would go out of business - end of story. However, the problem of the US mortgage defaults was spread across the financial system.

• Mortgage companies in the US borrowed from other financial institutions to lend mortgages. They sold collateralised mortgage debt in the form of CDOs to other banks and financial institutions. This was a kind of insurance for the mortgage companies. It means that other banks shared the risk of these subprime mortgages.
• Because these subprime mortgage debts were bought by 'responsible' banks like Morgan Stanley, Lehman Brothers e.t.c. risk agencies gave these highly dubious and risky debt bundles triple A safety ratings. Thus banks either ignored or were unaware of how risky their financial position was.
• Therefore, when mortgage defaults in the US occured, many banks and financial institutions around the world had to write off bad assets. E.g. AIG had been insuring many of these mortgage debts so was faced with huge losses
• The extent of this bad debt is estimated by the IMF to be close to £1.3trillion.
  

Freezing of Money Markets.

• In addition to bad debts, the other problem was one of confidence. Because many banks had lost money and had a deterioration in their balance sheets. They couldn't afford to lend to other banks. This caused a shortage of liquidity in money markets.
• Banks usually rely on lending to each other to conduct every day business. But, after the first wave of credit losses, banks could no longer raise sufficient finance.
• For example, in the UK, the Northern Rock was particularly exposed to money markets. It had relied on borrowing money on the money markets to fund its daily business. In 2007, it simply couldn't raise enough money on the financial markets and eventually had to be nationalised by the UK government.
• Because banks were short of liquidity, they have been selling assets such as their mortgage bundles. This caused further falls in asset prices, further liquidity shortages and further deterioration in bank balance sheets. (The Paulson plan is to try to reverse this cycle by the government buying these financial assets no one else wants to buy.)
  

The Vicious Cycle of the Financial Crisis

1. Share Prices

Because banks have lost money, people have been selling shares in banks. This fall in their share prices was speeded up by aggressive 'shorting' of banking stocks. The fall in share prices have compounded the problem of banks because

1. investors / consumers lose confidence
2. More difficult to raise finance on the stock market.

Part of the UK plan is to buy bank share capital to give greater confidence to the banks and enable them to raise sufficient finance.

2. Housing Markets

The shortage of finance means that banks have had to reduce lending, especially mortgages. The shortage of mortgages has caused further falls in house prices, especially in the UK. Falling house prices are magnifying the loss of banks as more default on their mortgage and loan payments.

3. Economy

Falling house prices, shortage of finance and collapsing confidence have caused the 'real economy' to decline. Investment and consumer spending has fallen therefore major economies face recession and rising unemployment. The rising unemployment increases the chance of more mortgage defaults and further bank losses.

Further Reading

• What can we learn from financial crisis
• A Humorous look at subprime crisis (actually quite educational)
  
• Essays on the credit crunch
• Boom and Bust in US housing market
  

When I googled 'Why Recession' I noticed that 5 out of the top 10 results were saying that recessions were good. I happen to disagree (unless your the manufacture of soup or a debt collector, recessions are damaging for the economy and more importantly cause economic hardship for many in the economy.) This is a collection of some essays I have written on Recessions in recent months. If you have any other questions about recessions, feel free to leave a comment.

Defining Recessions

• Definition of A Recession
• Simple Guide To Recessions

Are Recessions Good or Bad?

• Can A Recession really be a good thing?
• Does Anyone Benefit from A Recession
  
• Good investments for a Recession
  
• What Happens in A Recession?
• Problems of Recession for Business
• How Damaging are Recessions?

Causes of Recessions

• Video on Causes of Current Recession
• Causes of Great Depression
  
• How Long Do Recessions Last?
• Do Free Markets cause Recession?
  
• Why Recessions can Last a Long Time
  
• How To Survive a Recession
• Causes of Recession - what you would write in an A Level essay
• Do Falling share prices cause Recession?
  

Dealing With Recessions

• Can US and UK avoid Recession? (Jan)
• How To Avoid Recessions
• Can Tax Cuts Avoid A Recession
  
• Problems in Recovering from Recessions

Examples of Recession

• The Great Depression
• UK Recession of 1981
  
• UK Recession of 1991-92
• Why is US Facing Recession - 2008
• Whose Fault is the Recession - 2008
  

An interesting article at the New York Times by Paul Krugman - Moment of Truth. It explains the need for a coordinated response to an international crisis. It also suggests that the British response of providing capital to banks directly will better help restore the battered money markets. It appears the US Treasury is slowly coming around to the idea that there initial plan to buy toxic mortgage debt is a bad way to spend $700bn.

The Stock Markets have been plummeting again this morning. There is a real danger that if a powerful coordinated response is not generated, the markets could slip beyond our grasp.

In my recent essay on the causes of The Great Depression, it was interesting to note how many similarities there were between 1929 and now. Of course, there are differences, but, it is still cause for concern.

Amidst all the doom and gloom (see Economist article - Bad or Worse), I couldn't resist sharing this piece of satire, which wonderfully sends up all the recent government bailouts.

"A game of Monopoly being played by the Henderson family of Watford took a surprise twist today when the Bank of England stepped in with a rescue package to save one of the key players, Mr Henderson, from what the Chancellor described as ‘almost certain bankruptcy.’

The deal, which had been thrashed out in the early hours between Alistair Darling and Mr Henderson, who was acting as the banker, means that each player will receive a £1 billion pound injection of cash, (although this may take some time to count out what with having to use up all the yellow one pound notes). The short-term borrowing deal led to furious protests from the rest of the Henderson family, who complained that it was unfair to use their money to bail out Mr Henderson so that he could go back to ripping them off...."

From: News Biscuit

• The UK bailout focuses on recapitalising the banking system. It means government money directly goes to improve the balance sheets of banks. With more capital, it is hoped banks will be able to go back to their business of lending to firms and consumers. Government also offer security to bank loans.
  
• The US bailout focuses on buying bad debts that nobody currently wants. Indirectly, this helps banks balance sheets because they are able to raise money from the sale
• The UK government gets shares in the banks. The US governments gets the toxic mortgage debt and loans.

Overall, I feel the UK scheme will have more affect in securing the banking system. It also means the onus is on banks to deal with the bad debts, rather than the government choosing which debts to buy.

• In the long run, I think owning shares in banks is likely to give the taxpayer the best chance of getting a decent return.
• Interestingly, the UK model follows very closely what Warren Buffet did to Goldman Sachs and General Motors. He bought an investment in these 2 companies in return for preference shares. At the end of the crisis Goldman Sachs and General Motors have the option to buy back these shares for a premium. But, in the short term they get enough capital to avoid a crisis. Warren Buffet is likely to make a good profit on this deal.
  
• Many are now asking why the US government committed to buying $700bn of useless assets when they would be better off directly recapitalising banks and gaining shares for the taxpayer?

Although there are different definitions of recessions, most go along with the concept that falling real output constitutes a recession. (see: definition of Recession) The reasons for recessions are varied. Each recession has similarities but also differences. These are a few examples of major recessions.


Why Great Depression Occured

• Stock Market crash
• Banking Collapse led to hoarding of money and fall in investment
• Deflation caused even more falls in consumer spending
• End of Boom period and lax credit of 1920s
• Ineffective response of governments. - Failure to rescue banks, failure to increase aggregate demand
• Fall in Money Supply due to bank collapse

Note, some factors are caused by the depression and therefore make it worse. For example, because of the recession, prices fall causing deflation. The deflation made the depression worse. Because of the fall in output, unemployment rose. Rising unemployment reduced spending by more.

Government Blame: 9/10 UK government was stupidly stubborn to try and return to the gold standard on the old 1914 level. US monetary authorities allowed an unsustainable credit boom. The response to the depression made things worse. The UK response to cut unemployment benefits and increase income tax in a vain attempt to balance the budget, highlighted the paucity of economic understanding by economists. Increasing tariffs only made things worse.

See: Causes of Great Depression

1981 Recession

Background: High inflation and wage inflation of the 1970s.

• To reduce inflation, government pursued Monetarist policies. - high interest rates, high taxes and attempted to balance the budget.
• This caused a fall in money supply and inflation, but, in trying to reach a target for money supply, they deflated the economy too much.
• Problems of UK were exacerbated by high value of sterling. Sterling was high because of - discovering oil in north sea and high interest rates.
• The recession particularly affected the manufacturing recession. Manufacturing output fell by a third. Mrs Thatcher claimed recession necessary to get rid of inefficient firms. But, recession was much deeper than necessary. Famous letter to the Times signed by 300 economists criticising the government (see: Economy under Thatcher 79-84)
• UK Economic Recession 1981
  

Government Blame 8/10 - There was a need to reduce inflation the government inherited, but, in sticking to Monetarist principles and targetting misleading money supply growth statistics, the deflation was more than necessary causing recession to be deeper and longer than it should have been.

1991 Recession

Background: Lawson boom of the late 80s. High economic growth, booming house prices and rising inflation. Government claimed their had been an 'economic miracle' and trend rate of growth had increased. But, this was not the case. The boom caused inflation.

• To reduce inflation, the UK joined the ERM in 1990 (fixed value of sterling against the D Mark). The exchange rate value was too high for UK's deteriorating economic situation. To maintain high value of exchange rates, government forced to increase interest rates to 12% (Rose to 15% in one desparate day). These high interest rates reduced inflation, but,
• Caused rise in home repossessions, people couldn't afford mortgages. House price boom turned to bust.
• Falling house prices, high exchange rate and high interest rates caused dramatic fall in consumer spending and therefore recession.

Eventually, UK forced to leave ERM. This allowed interest rates to fall and economy recover.

Government Blame - 9/10 Government allowed an unsustainable boom, believing its own rhetoric of an economic miracle which had not materialised. They then pursued the wrong strategy to reduce inflation - Keeping interest rates stubbornly high to pursue a false goal of exchange rate stability when the real problem was unemployment and falling consumer spending. UK Recession 1991

2008/09 Recession

Background: Stable economic growth and low inflation for much of the 2000s. However, boom in house prices, low saving ratios, expansion of mortgage credit and rise in personal debt.

Causes:

• Credit crunch. Stemming from US, banks lost money in bad subprime mortgage debts. These debts had been sold onto other banks. This meant a shortage of credit in the financial sector. Lending fell, house prices fell and therefore consumer spending and investment fell.
• Cost push inflation. The impact of falling consumer spending and falling house prices was worsened by cost push inflation (rising oil prices) which squeezed disposable incomes.

Government Blame 5/10. Governments weren't the main perpetrators behind the credit crisis. But, they can be criticised for lack of sufficient regulatory oversight. US government could have done more to prevent a housing bubble and bust and excessive growth of consumer debt and borrowing
Oil price increase beyond governments control.
Credit crunch, collapsing banks and cost push inflation gave Government difficult problems to deal with.
See: Video on Causes of Current Recession

Of the 4 recessions, highlighted here, I am inclined to blame the government the least for the current recession.

In a recent post, I looked at the difficulties facing the government as they seek to avoid a serious economic recession - problems of avoiding recession
Today the government and bank of England have tried to act decisively to deal with growing uncertainty. Firstly, interest rates have been cut by 0.5%. Secondly, the government has offered help for the beleagured banking system.

The UK bailout Plan involves

1. Banks Selling Shares to Government. - £50 billion (or £2,000 for every taxpayer)

• The Government is injecting money into the banking system in return for taxpayers gaining shares in the banks. (These shares could be preference shares, ordinary shares or PIBS Permanent Interest Bearing Shares)
• In effect it is part nationalisation of the banking system.
• Seven Banks - Abbey, Barclays, HBOS, HSBC, Lloyds TSB, Nationwide Building Society, Royal Bank of Scotland and Standard Chartered have already taken part in the scheme. As these banks and one building society need to raise their cash ratios.
• £50bn is a huge sum for the treasury to absorb. The annual NHS budget is about £75bn.
  

2. Government Guarantee for Debt. - £250bn

The government is offering upto £250 billion to guarantee banks debts. This makes it easier for banks to sell short and medium term debts to raise finance and improve their liquidity. Note: this does not mean it will necessarily cost the taxpayer £250bn. It means the government is acting as guarantor, which helps give banks confidence.

3. Extra Liquidity to Help Money Markets - £200bn

The Bank of England will be injecting a further £200bn into the short term money markets to help unfreeze interbank lending, which is important for banking system.

What Does Bailout Mean for The Taxpayer?

In the short term, it means an increase in government borrowing and national debt. In the long term, it depends how banking shares fare. If shares in banks recover, the government could profit. If bank shares continue to slide, the government will lose out.

It is hoped that decisive government intervention will help solve the paralysis facing the banks. However, A report by the IMF suggests that the scope of bad debts in the banking system are higher than previously thought, meaning more write offs and problems for banks could be occuring soon.

Benefits of Scheme

• It is important that banks are able to lend to consumers and firms. Without lending investment will fall dramatically causing a bigger downturn and longer recession.
• Decisive government intervention may help restore confidence in financial markets. With more confidence the banking system may need less intervention and be able to solve its own problems.

The Great Depression was a period of unprecedented decline in economic activity. It is generally agreed to have occurred between 1929 and 1939. Although parts of the economy had begun to recover by 1936, high unemployment persisted until the Second World War.

Background To Great Depression:

• The 1920s witnessed an economic boom in the US (typified by Ford Motor cars, which made a car within the grasp of ordinary workers for the first time). Industrial output expanded very rapidly. Sales were often promoted through buying on credit. However, by early 1929, the steam had gone out of the economy and output was beginning to fall.
• The stock market had boomed to record levels. Price to earning ratios were above historical averages.
• The US Agricultural sector had been in recession for many more years
• The UK economy had been experiencing deflation and high unemployment for much of the 1920s. This was mainly due to the cost of the first world war and attempting to rejoin the Gold standard at a pre world war 1 rate. This meant Sterling was overvalued causing lower exports and slower growth. The US tried to help the UK stay in the gold standard. That meant inflating the US economy, which contributed to the credit boom of the 1920s.

Causes of Great Depression

Stock Market Crash of October 1929

During September and October a few firms posted disappointing results causing share prices to fall. On October 28th (Black Monday), the decline in prices turned into a crash has share prices fell 13%. Panic spread throughout the stock exchange as people sought to unload their shares. On Tuesday there was another collapse in prices known as 'Black Tuesday'. Although shares recovered a little in 1930, confidence had evaporated and problems spread to the rest of the financial system. Share prices would fall even more in 1932 as the depression deepened. By 1932, The stock market fell 89% from its September 1929 peak. It was at a level not seen since the nineteenth century.

• Falling share prices caused a collapse in confidence and consumer wealth. Spending fell and the decline in confidence precipitated a desire for savers to withdraw money from their banks.

Bank Failures

In the first 10 months of 1930 alone, 744 US banks went bankrupt and savers lost their savings. In a desperate bid to raise money, they also tried to call in their loans before people had time to repay them. As banks went bankrupt, it only increased the demand for other savers to withdraw money from banks. Long queues of people wanting to withdraw their savings was a common sight. The authorities appeared unable to stop bank runs and the collapse in confidence in the banking system. Many agree, that it was this failure of the banking system which was the most powerful cause of economic depression.

• Because of the banking crisis, Banks reduced lending, there was a fall in investment. People lost savings and so reduced consumer spending. The impact on economic confidence was disastrous.

Deflation

With falling output, prices began to fall. Deflation created additional problems.

• It increased the difficulty of paying off debts taken out during 1920s
• Falling prices, encouraged people to hoard cash rather than spend (Keynes called this the paradox of thrift)
• Increased real wage unemployment (workers reluctant to accept nominal wage cuts, caused real wages to rise creating additional unemployment)

Unemployment and Negative Multiplier Effect.

As banks went bankrupt, consumer spending and investment fell dramatically. Output fell, unemployment rose causing a negative multiplier effect. In the 1930s, the unemployment received little relief beyond the soup kitchen. Therefore, the unemployed dramatically reduced their spending.

Global Downturn.

America had lent substantial amounts to Europe and UK, to help rebuild after first world war. Therefore, there was a strong link between the US economy and the rest of the world. The US downturn soon spread to the rest of the world as America called in loans, Europe couldn't afford to pay back. This global recession was exacerbated by imposing new tariffs such as Smoot-Hawley which restricted trade further.

Different Views of the Great Depression

Monetarists View

Monetarists highlight the importance of a fall in the money supply. They point out that between 1929 and 1932, the Federal reserve allowed the money supply (Measured by M2) to fall by a third. In particular, Monetarists such as Friedman criticise the decisions of the Fed not to save banks going bankrupt. They say that because the money supply fell so much an ordinary recession turned into a major deflationary depression.

Austrian View

Austrian school of Economists such as Hayek and Ludwig Von Mises place much of the blame on an unsustainable credit boom in the 1920s. In particular, they point to the decision to inflate the US economy to try and help the UK remain on the Gold standard at a rate which was too high. They argue after this unsustainable credit boom a recession became inevitable. The Austrian school doesn't accept the Friedman analysis that falling money supply was the main problem. They argue it was the loss of confidence in the banking system which caused the most damage.

Keynesian View

Keynes emphasised the importance of a fundamental disequilibrium in real output. He saw the Great Depression as evidence that the classical models of economics were flawed.

• Classical economics assumed Real Output would automatically return to equilibrium (full employment levels); but the great depression showed this to be not true.
  
• Keynes said the problem was lack of aggregate demand. Keynes argued passionately that governments should intervene in the economy to stimulate demand through public works scheme - higher spending and borrowing.
• Keynes heavily criticised the UK government's decision to try balance the budget in 1930 through higher taxes and lower benefits. He said this only worsened the situation.
  
• Keynes also pointed to the paradox of thrift.

Marxist View

The Marxist View saw the Great Depression as heralding the imminent collapse of global capitalism. With unemployment over 25%, Marxists held that this showed the inherent instability and failure of the capitalist model. Furthermore, they pointed to the Soviet Union as a country which was able to overcome the great depression through state sponsored economic planning.

How Important was Stock Market Crash of 1929?

The stock market crash of October 1929, was certainly a factor which precipitated events. It did cause a decline in wealth and severely affected confidence. However, changes in share prices were a reflection of the underlying boom and bust in the economy. Also a collapse in share prices might not have caused the great depression, if bank failures had been avoided. In October 1987, share prices fell by even more (22%) than black Monday. But, it didn't cause an economic recession.

- Essays on the Great Depression by Ben S. Bernanke at Amazon.co.uk
Essays on the Great Depression by Ben S. Bernanke at Amazon.com

• Essays on Credit Crunch
  
• About Great Depression
• Photos of Great Depression
  

A couple of weeks ago, I was writing about the US National Debt. I said the debt was $9.7 trillion. Now the National Debt has passed $10 trillion, but the National debt clock didn't have enough spaces. They had to squeeze a 1 in by the dollar sign. A new debt clock will be made with 2 extra spaces (presumably for when it gets to $100 trillion)

The forecast national debt for 2009 is $11.3 trillion. But, that forecast looks rather optimistic already. - US National Debt Forecast

Readers Question: Can A Recession Be Avoided?

No,With the UK already having stagnating growth, it is almost inevitable the economy will decline in the last quarter of this year and early in next year. The big question is: How long will the recession last? How deep will the recession be?

To reduce the impact of the recession the Government and Monetary authorities can try:

1. Cutting Interest Rates (monetary policy) to try and boost spending and investment
2. Cut income tax and / or increase government spending (fiscal policy) to try and increase Aggregate Demand
3. Ensure stability in banking system and financial system and overcome worst impact of credit crunch on lending and housing market

The credit crunch and banking problems is a major factor in contributing to the present recession. However, 'creating stability in the banking system' is easier said than done. No one is quite sure how much or what kind of government intervention is required. There is also the danger that government intervention might not improve things but just reinforce the bad decisions made by the banks.

Cutting interest rates should help alleviate problems like mortgage defaults and it may encourage spending and investment. However, as I say in the video; I fear there is a danger people may be slow to respond to interest rate cuts in the current climate.
Expansionary fiscal policy can also help. I believe increased government spending would be more helpful that tax cuts. But, with government borrowing already high, this policy is limited.

The experience of Japan, gives little grounds for optimism. With falling asset prices, Japan tried everything to boost economic activity. 0% interest rates, expansionary fiscal policy (I think Japan's National debt is over 150% of GDP) but struggled for many years to get out of a deflationary spiral. I think we can avoid this. But, quite soon, this crisis may cause textbooks to have substantial rewrites.



See also: Video on Causes of Recession

The credit crunch has hit Europe with a vengeance. Whearas it used to be focused mainly in the US, it appears many European banks are now close to the brink. With some banks on the verge of bankruptcy or rapidly falling share prices, confidence in the banking system has evaporated. In this climate, savers became nervous and could start to withdraw their savings. The fear is of a new bank run which could undermine the banking system. At the moment, it is not so much private savers queuing up to withdraw their life savings, but financial institutions and corporate treasuries withdrawing short term deposits. This is causing serious liquidity problems.

If savers start withdrawing their cash, the banks are in trouble because they will not have sufficient liquidity to meet the demand for cash withdrawal.

One solution is for the government to explicitly guarantee all savings. (Currently the UK government guarantees the first £50,000 of savings).

The problem with the government guaranteeing all savings is that it could encourage irresponsible behaviour by banks who don’t have to worry because the government can clean up their mess. This is why the UK wants to avoid making an explicit guarantee for the £2 tillion worth of UK deposits. Yesterday, the chancellor Alistair Darling was rather vague in saying the Government will do:
“Whatever is necessary to ensure stability of the financial system” – Without saying what this might involve.

The problem is that first Ireland and then Germany have made a guarantee to secure all bank deposits (in Germany it is just for private investors)
Therefore, if you are a nervous investor worried about your bank collapsing (and if share prices are anything to go by, things don’t look good at moment) you could switch your savings to Ireland or Germany. At least there, savings are guaranteed by government.

• If people do switch to Ireland or Germany, which is a rational step to make, then the UK banking system will suffer.
• Because Germany and Ireland have taken the step of guaranteeing savings, they will get an inflow of savings and countries which don't have a guarantee will suffer an outflow. This withdrawal of money makes the situation more difficult for the UK banking system.
  
• This is why other countries such as Austria, Denmark, Greece and Sweden are indicating they will follow Germany’s example.
• The best solution would have been to have a European wide response, Germany and Ireland have pursued a strategy which maximises their interests. But, this will probably lead to all countries having to follow suit. Therefore, the European banking system may end up being 100% guaranteed by the government, which may be a sub optimal solution in the long term.
• Game Theory looks at the best response of an agent given response of others. The best outcome in game theory is when the players collude and agree on a coordinated outcome. When people pursue selfish ends they often make things worse for everyone, including themselves.
  

Unfortunately, in a financial crisis, the appeal of coordinated responses often disappears. It is why in the Great Depression, countries increased tariff protection. This tariff protection made the slump worse for everyone. But, people wanted to see some action and action, even if it didn't help.

It may be that, to secure confidence in the banking sector drastic action is needed. In a crisis the problem of moral hazard may be less important than protecting your banking system. Making explicit guarantees for savings may merely make explicit something that was long implicit.

One solution being muted is for the government to take a share in the major banks, in return for liquidity and higher guarantees.

Governments have been borrowing for centuries. The figures for National Debt are staggering. In the US, National debt is $9.5trillion. From a personal perspective, we know debt is a bad thing. Therefore, it seems ridiculous that national debt can be so large. How much should we worry about these levels of national debt?

One argument says that an increase in the national debt doesn't cause any problems. What happens is that by borrowing we merely enable the present taxpayer to enjoy a higher disposable income now rather than in the future. A cut in the National debt, would mean higher taxes now, rather than later. Therefore, National debt is just a way to spread national output amongst different generations.

Furthermore, National Debt has been much higher in the past. During the second world war, the national debt of the UK and US, reached very high figures of up to 150% of GDP. This is an example, of how a country can borrow during times of a national crisis and pay back the debt over a period of time. Therefore, national debt can be an effective way to deal with economic shocks such as recessions, financial crisis and world wars.

Another factor is that economic growth usually makes it easier to pay back national debt. If GDP increases faster than national debt, then we need a smaller % of incomes to pay the debt interest payments. If GDP growth averages 2.5% a year, then increasing national debt by 2.5% means we will spend the same percentage of income on debt payments (assuming constant interest rates)

• An analogy. When I took out a mortgage loan of £140,000, I was left with mortgage payments of £800 a month. In 2004, this was nearly 40% of my income. However, if my income increases by 3% a year. In 20 years time, it will be much easier to pay that mortgage payment of £800, it will hopefully be 15% of my income. To buy a house, it makes sense to borrow a mortgage and pay back over 30-40 years.
  

However, although National Debt can be effectively managed, there are real concerns when debt grows faster than National Income.

Reasons to Be Concerned About Current Government Borrowing Levels

1. Government is not just borrowing for a short lived crisis. Government borrowing reflects a fundamental disequilibirum between spending and tax revenue. Borrowing as a % of GDP has been increasing in past few years, despite economic growth.

2. Present Government borrowing is not to finance investment in the economy. A large percentage of the debt is to finance transfer payments to an ageing population. If the government was borrowing to invest in infrastructure - new roads, communications. It might help to increase the growth rate in the long term. This in turn, would lead to higher tax revenues. However, paying pensions and health care to an ageing population, will do nothing to facilitate economic growth and higher tax revenues. It will get more and more difficult to finance the national debt.

3. Inflationary Pressure. There is a genuine concern that higher levels of national debt can cause inflation. If debt becomes too high, there may be insufficient investors to buy the government securities (the way of financing the debt). Therefore, the government may be tempted (or forced) to fill the shortfall in revenue by printing money. Printing money and increasing the money supply, will lead to inflation. The problem with inflation, is that it devalues the value of bonds, people will sell bonds, leading to higher interest rates on bonds and higher debt interest payments. If investors see inflation is getting out of control, people will not want to hold bonds. Foreign investors will sell their securities and this will cause a devaluation in the currency. This is particularly a problem for the US, where foreign countries hold a high % of the national debt.
The hyperinflation of Germany in 1922-23 was caused by the government printing money to finance reparation payments to the allies.

4. Crowding Out. It is argued that if government borrowing increases, it will cause crowding out of the private sector. If the private sector buy bonds it means the private sector has less funds for private sector investment. Also, if borrowing increases, interest rates may rise. Higher interest rates also reduce private sector spending and investment.

5. As National Debt increases as a % of GDP, it means that the interest payments as a % of GDP increase. Therefore, higher levels of taxes have to be spent on just financing the national debt.

• US National Debt as a % of GDP
  
• US National Debt
• UK National Debt
  

Readers Question: What is More Likely - Inflation or Deflation? This seems paradoxical as inflation is the opposite of deflation - why might we be concerned with both at the present time?

Is Deflation a possibility?

Deflation is a fall in the general price level. It is quite rare amongst Western Economies. The last serious period of deflation was during the Great Depression of the 1930s (though Japan experienced deflation during 90s and 00s).

Deflation usually occurs because of a serious economic slowdown. If the present slowdown in economic growth turned into a major recession, deflation could become a real possibility. Deflation could occur because of:

• Falling house prices reducing spending
• Falling value of shares
• Contraction in investment caused by banks being unwilling or unable to lend.
• Falling economic growth causing firms to try cut prices and possibly wages.

Deflation is generally considered to be very harmful for the economy as it exacerbates any recession through discouraging further spending (During periods of deflation people delay purchases because they think they will be cheaper in the future.)

However, at the moment, deflation is unlikely. We have cost push inflation and economic activity would need a very large decline before deflation becomes likely.

Could US experience Hyperinflation?

Again this is very unlikely. Although inflation is currently high, this is likely to drop in the coming months due to falling oil prices and a slowing economy.

Hyperinflation could only be a problem if National debt got out of control and the government started to print money. I examined the likelyhood of this occuring in - US Dollar Collapse?

Readers Question: If the banking system is collapsing, why pump money into failed money markets?

• The banking system has not completely failed. Many mortgage loans are not completely worthless, as is often stated. Even if general mortgage defaults reached say 10% ( a high figure), 90% would be paying back their mortgage with interest.
• The problem is one of confidence. Even though some mortgage loans are sound and will be paid back, banks still don't want to (or can't) buy these mortgage backed securities.
  
• Therefore, banks don't want to lend anyone else money because they are already overstretched and need to attract savings not take on more debt. You could argue the current market price of mortgage debts undervalues their true value.
  
• Therefore, the government could be buying them at a discount on their expected return. There is even a chance the government could profit from buying mortgage securities, when people later repay in full.
• It is hoped that injecting liquidity into the market will loosen the fear over lending and help banking system go back to normal operating.
  

• If banks are allowed to go bankrupt it affects the wider economy. Consumer spending will fall, investment will fall, output will fall and unemployment will rise.

Banks may not deserve to be bailed out. (why bailout banks) But, if we don't prevent them going bankrupt, we will face a bigger economic costs in terms of a deeper recession and higher unemployment.

Rescuing banks is also a chance to introduce tighter legislation so that the banking system don't make the same mistakes again.

This is the argument for a bailout. However, of course, there are many criticisms, such as

• moral hazard
• Mortgage defaults could get worse as the economy enters recession.
• Banks may try to get rid of their worst performing bonds and loans. The government will be left with the worst.
• $700bn may not be enough to get deal with the 'bad debts in the system.

The Financial crisis is contributing to a deteriorating economic situation in both US and UK. The UK, German and Spanish economies are all forecast to have negative growth in the next quarter. To deal with this slowdown in the economy, governments could use expansionary fiscal policy (a Keynesian approach).

Expansionary fiscal policy involve cutting taxes and or increasing government spending. In theory, this injection of money into the economy increases aggregate demand and helps to increase economic growth and prevent a recession.

The US has already tried an economic stimulus package (mainly tax cuts) earlier in the year, with limited affects.

Cutting taxes may not prevent recession because:

1. People may save tax cuts. The savings ratios is very low (close to 0%). Therefore, with low confidence, people may not spend a tax cut, but use it to pay off debts or increase their savings. Therefore, consumer spending may not increase.

2. Other Factors May Outweigh tax cuts. A cut in income tax may increase spending. However, this positive effect may be outweighed by the decline in house prices and the consequent negative wealth effect. Alternatively, the difficulties of borrowing in the credit crunch may keep investment low. To overcome the economic slowdown may require a very large fiscal stimulus.

3. Crowding Out. Expansionary fiscal policy leads to higher government borrowing. To finance the growing national debt, bond interest rates may be forced upwards. This can put upward pressure on interest rates and therefore reduce consumer spending. (This is known as financial crowding out)

4. Also government borrowing may cause resource crowding out. If the government borrows, it borrows from the private sector. Therefore, although the government spend more, the private sector have less to spend and invest.

5. Government borrowing is already understrain with high levels of National debt. Therefore, governments are limited in their ability to pursue expansionary fiscal policy. In the UK, the government have just broken their own rules on national debt. Expansionary fiscal policy would increase public debt even more.

Tax Cut vs Government Spending

Higher government spending on public works is likely to be more effective than tax cuts. This is because public spending directly affects output and jobs, whearas tax cuts may just be saved and not spent. Unfortunately, in the US the Bush administration seem to feel fiscal policy only involves tax cuts (often targetted at high earners, who are the most likely not to spend it)

Despite the limitations of fiscal policy. I still believe that in a recession increased government spending can help to kickstart the economy. I do not believe the philosophy of Monetarists that expansionary fiscal policy always has no real affect in the long run.

However, fiscal policy does not address the causes of the credit crisis; it attempts to deal with its consequences. In this particular crisis, with high debt levels and financial uncertainty, fiscal policy may be even less effective than usual.

At the moment, the focus is on finding short term solutions to the pressing problems - How to bail out banks? How to prevent money markets freezing? How to prevent a minor recession turning into a deep recession?

But, in the long term, there are many lessons to learn from the current financial / credit crisis.

1. The Financial Sector cannot be trusted to regulate itself.

The mantra of the 80s and 90s was 'free markets' and deregulation'. Wall Street told us free markets were best at allocating resources, and the complex derivatives markets helped increase efficiency of markets. The same people who cried for financial deregulation are now the same people who want and expect the biggest ever government bailout and or subsidy. It is like a gambler who has run up huge losses and now, rather than go bankrupt expects the government to pay off his debts so he can go back to his gambling habit.

• One example of lax regulation. - In the US, there was insufficient regulation of mortgages. This regulatory freedom allowed an unprecedented expansion of the mortgage industry; this involved aggressive selling of subprime mortgages to people who couldn't really afford it. This lack of regulatory oversight has caused unprecedented problems. Firstly, it fuelled a boom and bust in house prices. Secondly, it caused a series of loan defaults the global banking system is still struggling to deal with.
• Another example - allowing short selling on falling stocks. see: short selling explained
  

2. Moral Hazard

A major objection to the current government bailout is that it encourages future reckless behaviour. If a manufacturing firm goes bankrupt, it won't expect to get bailed out. Therefore, it will try hard to follow sensible management. The argument is that because banks have a privileged position, they feel they can rely on getting bailed out.

For example, after the dotcom boom and bust, the government cut interest rates aggressively to prevent a recession. However, by keeping interest rates too low for too long, they encouraged another boom and bust, this time in the housing market. The argument is that sometimes it is better to let things fail to deal with the fundamental disequilibrium. If you keep papering over the cracks, the underlying problem gets worse. This point is quite complicated, there are many caveats and issues to consider. But, one thing is clear, government intervention needs to be very careful so it does not create incentives to create more problems in future.

3. Traditional Business models will Come Back into fashion

In the UK, banks like the Halifax and Bradford & Bingley used to have a very sound, profitable business models. They collected savings from customers, and then lent out mortgages. They were careful who they lent to, and were scrupulous in checking income. This business model is still profitable, UK banks operating profits have been very high in recent years (in fact some argue they are too high and indicate monopoly power). The problem is that the banks entered new markets, which were a departure from the traditional business model. They lent more risky mortgages. But, also got involved in raising finance on the money markets and used derivatives to extend their balance sheet.

To make things simple, they started to borrow in order to lend more. They were lending money, which wasn't theirs. They would hedge these loans with other insurers. This meant their business became intricatly linked with the wider money markets. When the money markets were doing well, it looked a way to make more money. But, when the money markets seized up, it left them very exposed and their balance sheets looking very vulnerable.

What it means is that the mortgage sector will become more circumspect and banks will concentrate on core business models, rather than trading derivatives, and seeking spectacular short term profits in non productive activities.

4. Savings Ratios Need to Increase

The savings ratio has been very low in both the UK and US. In September 2008, the UK savings ratio dipped below 0% for the first time since 1958. This reflects the low savings and high volume of debt in the economy. The US has also seen record low savings ratios. The 2000s have seen a culture of debt become widespread. Personal debt has risen to an all time high.

5. Culture of Debt is Dangerous

A culture of debt is problematic because.
- It makes consumers, firms vulnerable to interest rate changes.
- Contributes to current account deficit
- Leaves unbalanced economy

See: Problems of Personal Debt

6. Boom and Bust in Asset Markets

Governments in UK and US did a good job in preventing boom and busts in the economic cycle. We haven't had high inflation and booms like in the Lawson Boom. However, whilst they were busy congratulating themselves on avoiding boom and busts in the economy, they ignored the problem of boom and busts in asset markets like the housing market (see: Boom and Bust in US Housing Market)

Bailing out a bank, is rather like going to the dentist to have a tooth pulled out. We hate having to do it, but, if we don't deal with the rotten tooth we feel we will only suffer more pain in the long term.

Quite a few readers ask, why should we bail out irresponsible banks, when we don't bailout manufacturing firms?

If a commercial bank like Halifax in the UK risked going bankrupt, savers would rush to get their money out. Last year, queues of people went to Northern Rock to withdraw their money (even though Northern Rock's problems was raising finance for mortgage sector)

The problem is that Halifax wouldn't have enough deposits to cover savers demands. Banks only keep a certain % of their deposits in cash. About 99% will be lent out in the form of mortgages and loans. The Halifax can't call this back at short notice therefore, people would be unable to get their cash out.

If people hear that others have lost their bank savings, they will want to withdraw their money from their bank - just in case it goes under. The panic and desire to withdraw your cash would spread throughout the banking system. Even banks which were relatively sound, would have large queues of people wanting to withdraw their money. (It is an irony, that what makes sense for you to do, creates problems for society)

If this happened the whole banking system could collapse. The banking system relies on confidence. It relies on the fact people won't want to withdraw their money all at once. If people do try to withdraw money, the bank will be incapable of dealing with it. If this happens, banks would not be able to lend money to consumers and firms to invest. It would cause a contraction in economic growth, and we could enter into a serious recession.

This kind of bank rush did occur in the Great Depression, and it is widely considered to have exacerbated the Great Depression. Therefore, there is a powerful precedent to avoid it happening again.

But What About Intermediary Banks?

Many banks which have shortage of liquidity are not commercial banks with savings, but investment banks like Lehman Brothers, Morgan Stanley or even Insurance Giants like AIG, who have been insuring bonds and bank loans. The problem is that commercial banks rely on interbank lending. They rely on being able to borrow from intermediaries on money markets to raise funds. These days banks lend more money than they have in savings. If the intermediary banks go under, it will worsen the balance sheet of all commercial banks and make it more likely they suffer from liquidity shortages.

As much as we dislike bailing out rich bankers, the problem is we don't want to see a situation where people stop using the banking system and the banking system is unable to lend money. This would cause a real economic downturn. Already business investment has been affected by a shortage of finance. If this was to significantly worsen, the recession could change into a depression.

Does That Mean Paulson's $700bn Plan is Good?

Not necessarily, just because we want to protect the banking system, it doesn't mean we have to go along with the first scheme which comes along. It is debatable whether buying worthless assets will do much to help. There may be better ways to prevent a banking collapse. - Questions about bailout

See also: Argument against bailing out banks

• The Cost of Government Bailouts

(BTW: This is the 500th post on this blog Economics Essays)

Readers Question: Why Do The Rich Get Richer and the Poor Get Poorer?

It is an interesting question, but, not entirely true. In the past 100 years, the living standards of the poorest 10% of the population has increased dramatically. Real incomes have increased, but, there has also been a reduction in relative poverty ( a reduction in the gap between rich and poor). This is a combination of rising real wages, better education and the introduction of government welfare support which guarantees a certain minimum standard of living.

In the post war period, the UK, US and other European countries generally had a reduction in income inequality. This was helped by periods of full employment, rising real wages and progressive tax and benefit systems.

However, since the early 1980s there has generally been a reversal of this trend. The rich have got richer, and the poor have become relatively poorer. (Inequality in US). (Inequality in UK) It is not that the real incomes of the lowest paid has fallen (though in some cases real incomes have been stagnant) but, they have fallen behind higher income earners. The gap between the highest paid and lowest paid has increased. In the past couple of decades it feels like the ‘rich have got richer and the poor have got poorer’. Why is This?

Reasons for Rising inequality in past 2 decades

Reforms to Welfare State. Governments have sought to retreat from expensive universal benefits. In the UK, benefits have been linked to inflation. This means that benefits have increased at a slower rate than real wages. Therefore, those surviving on state benefits have become worse off. It is also more difficult to get benefits in UK and US

Cut in Income Tax. Both the UK and US have seen cuts in the top rate of income tax, and increases in indirect taxes. This has made the tax system less progressive. (e.g. top rate of income tax in UK used to be 80% now it is 40%.

Importance of Skills in Global Economy. Arguably globalisataion and economic development have changed the nature of the economy. There is now less demand for unskilled manual labour. This is because there has been a shift in manufacturing to the east. Therefore, workers with low skills and qualifications have found it harder to get well paid work. However, those with good qualifications and education have seen significant rises in real pay. There has been a rise in bonuses for top executives.

Growth in Insider / Outsider Economy.

There has been a growth in the insider / outsider model. Basically, there has been an increase in the number of poorly paid, part time, temporary jobs which offer little protection. This is known as the ‘outsider’ economy. The other part of the economy ‘insider’ involves highly paid, secure jobs which are generally well paid.

Wealth.

High income earners have the ability to buy wealth, e.g. house. Therefore, the rich can benefit from rising asset prices, but, the poor cannot. Certainly wealth inequality is much greater than income inequality.

One question worth considering - Does it matter if there is an increase in inequality, as long as the poor become better off in absolute terms? e.g. If poorest section increase incomes by 3% and richest section increase incomes by 12%. Or would it be preferable if both rich and poor increased incomes by 2%?

Rich Countries Poor Countries

Another way to look at this question, is from the perspective of rich countries and poor countries. Poor countries e.g. in Sub Saharan Africa continue to struggle with low or negative economic growth. Rich countries have much higher growth rates. But, in some cases (e.g. China and India) poor countries have been catching up.


Related:

• Poverty, Inequality and Economic Growth