We are used to having low inflation. In living memory we have had rates of 10% and upto 28% in the 1970s. But, generally, we are used to relatively low inflation rates. Prices do rise, but, the rate is manageable. The whole economy is geared upto dealing with low inflation. What would be effect on the the economy if we ever had an inflation rate of over 100% or even 2000% ?

Contracts. Suppose you are a firm and assuming constant inflation you make a deal to deliver rental DVD's at £20 a month for the next 12 months. Such contracts are very common - some may even last for longer. If inflation stays at 2% everything is fine. However, if inflation jumped 100%, then by the end of the year a firm would find its costs would have increased 100% (e.g. postage rates can easily be changed by Royal Mail) but revenue stays the same. Therefore, by the end of the year you are making a loss and could be forced out of business. The firm could try breaking its contract and change prices, but, if you break a legal contract you could be sued. Thus hyperinflation can make contracts worthless.

Debts. Suppose you buy a Plasma TV for £400 on a 3 year interest free credit deals. This means a fixed monthly plan is set up for the next 3 years. The firm is assuming inflation stays low, but, if inflation rose to 100%, the monthly payments would fall in real value. (your wage will increase but debt payments won't) By the end of the 3 year deal, the firm would have lost out quite considerably. The person who bought on credit will find it much easier to pay the loan back. His wage will rise with inflation so the fixed monthly payments will be easier to pay back.

If you have a fixed repayment plan for a mortgage you will benefit as well.

Savings If inflation increased to 10%, Central banks may increase interest rates to 12% therefore savers will not see a reduction in the real value of their money. But, if inflation goes upto 100%, interest rates will probably not keep up. Therefore, savers will see the value of money declines. Their savings could be wiped out. This also causes financial panic - what is the point of keeping money in a bank if it is going to become worthless. This can create a dash for assets. People will try to convert any money into gold, furniture, antiques, foreign currency - anything to protect the value of savings. This can cause an outflow of money from the country an an outflow from banks leading to a fall in normal business practices.

Menu Costs. Inflation of 2%, means you can change prices once a year. Inflation of 500% means you probably have to update them every day. Time and resources are thus wasted.

Practical costs. High inflation means people will want to spend as soon as they get paid. During hyperinflation, people may seek to get paid twice a day and then spend it as soon as possible.

Lower Investment. With such disruption, firms will not want to invest.

The more you look around the economy, the more you realise how we take low inflation for granted and how much disruption would be caused by even a medium level of inflation.Hyperinflation may make interesting pictures - but, it's no joke for those caught up in the crisis.

• Causes of Hyperinflation

As an economist I usually understand why things occur, but, when it comes to making predictions and forecasts I feel pretty useless because it is often hard to predict what will happen. At least, I'm not alone. When oil prices were $150 a barrels, many started predicting the $200 barrel. Now that oil prices have fallen to $40, people are now predicting $25. It reminds me of the joke about the economists on a hiking trip in the Alps. Looking at a map, one economist says, according to my calculations, we are standing on the mountain 10 miles over there.

So I'm sure, in 12 months time, people will be able to come and have a good laugh at these predictions But, anyway, with all the necessary caveats, pre-emptive excuses and waivers, what could do well in 2009?

Gold. Traditionally does well in times of uncertainty and recession. With people looking for safe investment, gold fulfils that need. The slowdown in global growth has caused slower demand from countries like India. But, with continuing uncertainty in finance markets gold should continue to do well and what is best to avoid?

Oil. Oil is a tricky one. It has shown to be tremendously volatile. The slowdown in global growth has led to lower demand; but this small fall in demand has led to a huge fall in the price. Some oil analysts predict oil could fall to $25. But, I can't help feeling at $25 the price oil is hopeless undervalued for the long term. The IEA have changed their predictions and stated that oil supplies will fall quicker than anticipated. As the global economy recovers (and this may not happen until late 2009, we could easily see oil prices return to early 2008 levels. Oil seems more volatile than the stock market. But, for a long term investment buying at these levels could give a really good return in a couple of years.

Housing. In 2009, I see no end to the fall in house prices. Analysts predict house price falls of between 10 - 30%, and I would agree with the median of these forecasts. With rising unemployment, and continued shortage of mortgages I can't see a change in the short term future of the housing market. In the long term, I believe UK house prices will recover - there is simply a long term shortage of supply compared to demand. But, there is a very powerful negative momentum which will not be broken in 2009.

Stock Market. Price to earnings ratios have fallen considerably, meaning that shares are offering better value than for a long time. However, it has proved difficult to call the bottom of the market. 2009, could lead to more bad news for the financial markets as the credit crunch and recession continue to cause problems for firms. One is tempted to say, that the stock market has priced most of the bad news about the economy into prices. If we avoid more financial meltdowns, such as Lehman Brothers declaring bankruptcy then maybe shares will be able to recover in 2009. But, this raises the great uncertainty of 2009 - will we see more banks on the brink of collapse as banks suffer from more repossessions?

Mattresses. With deflation and negative interest rates on US treasuries, Warren Buffet has been advising a buy for firms selling mattresses - a great place to hoard all your cash.

Pound Sterling. The Pound has had a miserable year, falling from 1.4 to the Euro to achieve parity. I don't think the decline will continue into 2009. I think the Euro is starting to look overvalued. The UK is not alone in having high public sector debt and falling interest rates. Mind you, I already said that the pound would stop falling a few months ago, and it is very nicely ignored my predictions so far.

Dollar. The dollar is a really difficult one. Some are confidently predicting its ultimate collapse and demise on the back of accelerating money supply and increased national debt. Yet, the dollar has proved remarkably resilient with people switching to dollars as a means to hoard cash and get out of emerging economies. I can't see US interest rates increasing in 2009. On purchasing power parity levels, the dollar is not overvalued, and it is difficult to know who it would collapse against. The strength of the Euro, belies the fact the Eurozone is also in a deep recession with high levels of debt.

Other Predictions for 2009

Unemployment. Unemployment will increase in the UK and the US. Alas, this is the easiest prediction to make. It can be made with great assurance, because unemployment is a lagging indicator. The fiscal injections could take upto 8 months to have an effect. By, that time, unemployment will continue to rise.

End of recession. I think this will be a pretty steep and long lasting recession. The government's fiscal response and interest rates cuts will slowly start to have an effect. But, it is likely to take over 6 months.

Inflation As I write this in December 2008, inflation is 4.5%, but, this is almost certain to fall in 2009. The big question is how much? The MPC say there is no danger of deflation; but it remains a fear nevertheless.

The Federal Reserve are buying 30 year Treasury Bills in an attempt to increase the money supply and stimulate economic activity.

At the moment banks are reluctant to lend to the private sector. This is because the recession has made lending to private companies quite risky. Also, banks are reluctant to lend to each other because of the credit crunch. Banks are buying 30 year treasury bonds because they are seen as a safe investment. They may only yield 2%, but with interest rates at 0-0.25%, it does represent some profit for a bank; in addition it is seen as safe.

Because the Fed is worried about deflation and lack of credit, they are trying to get the banks to resume more normal lending practices (lending to each other and lending to private sector.

The Federal Reserve are buying treasury bonds because:

• By buying bonds, the value increases and the interest rate on them declines. The Fed are trying to reduce interest rates on long term bonds to encourage banks to spend less money on buying Treasury bonds and lend more to private sector. (If treasury yields fell to 0%, it is less attractive to buy bonds)
• The Federal Reserve are also trying to improve the balance sheet of banks by buying 'toxic assets' - mortgage backed securities which currently have little market value.

If successful, this will create inflationary expectations (rather than deflation), encourage lending and therefore encourage economic growth.

Problems With This Scheme

1. The Federal Reserve are increasing the monetary base, there is a danger this could lead to high levels of inflation, when the velocity of circulation picks up.
2. Increasing quantity of US dollars and reducing interest rates on bonds is likely to reduce value of dollar, so dollar is likely to fall.
3. US National Debt is over 73% of GDP and is increasing all the time. This relies on people being willing to buy bonds and finance the debt.
4. The worry is that lower interest rates and a falling dollar, will discourage foreign investors from holding US treasury bills and bonds. Then the US would struggle to finance its national debt. This would then cause either inflation (potentially very high) or an increase in interest rates to attract savers.

A key issues is whether:

• Investors retain trust in the dollar
• The US government's credit worthiness - If people feared US government could default this would create real problems for the US dollar and US deficit.

• Quantative Easing policy in US

I will have a slower posting schedule over the Christmas and New Year Period. I'm sure in the New Year, there will be certainly no shortage of topics to write about. To keep upto date, you can subscribe by RSS or receive free updates by email.

Economic Year in Review - 2008

It's been a tumultuous year with the financial crisis, which began last year, spreading unremittingly into the real economy. A crisis which once seemed to be affecting exotically named items such as CDO's, Credit Default swaps, and libor interbank lending rates, is now affecting people in the most personal and painful ways - home repossession, rising unemployment and a growing uncertainty over the future outlook.

It has been a year when many new phrases such as 'cash for trash' have entered the public lexicon. We have been learning the meaning of words such as credit default swaps - and realising that we are not entirely happy that aparantely this unregulated and previously obscure market is worth on paper $65 trillion.

With economics making front page headlines, there has been a big increase in interest in this economics blog. I hope it has helped explain some of the issues at stake. I have learnt alot this year - not least, economic theory can struggle to explain and forecast a crisis such as the one we are facing. The fact that there are fears over both hyperinflation and deflation for next year indicate the great uncertainty we are facing.

These are a few selected article from the past year.

• What Went Wrong with the US Economy - Jan 2008. A look at the fundamental weaknesses of the US economy. This was written before the US went into recession. - see also: Why Us is facing Recession
• Costs and Benefits of a Falling dollar - This could be another issue for 2009, as low interest rates and increased debt and money supply push the dollar lower. - Applicable also for Pound Sterling which has had a miserable year.
• Problems with Bailing out the Finance Sector - It is said that some banks are too big to fail - and this is probably true; collapsing banks were the main reason behind the Wall Street crash of 1929 becoming the Great Depression.
• Hyperfinflation - causes and Examples - After deflation, some worry that the next problem could be hyperinflation as the Fed increase money supply to finance national debt .
• Debt in the US - external debt, personal debt, National debt - It's all at record levels
• Can Recessions be avoided? July 2008 - a shorter essay would have just said no.
• Will Dollar Collapse? - in 2009, this essay may need revisiting as we see the impact of quantitive easing.
• US National Debt - Well, they had to get a new national debt clock to fit the fact it had gone over $10 trillion.

UK Economy

• The Problem with Government Borrowing There has been great interest in UK public sector debt. It is lower than many of our international competitors, but, we are doing our best to try and catch up - showing there is at least one aspect where we would like to show our oneness with Europe.
  
• How Much National Debt does the UK have?
• Problem with Housing Market - You don't have to be an economist to know that now is not a good time to be an estate agent - and there is little crumbs of comfort for 2009
  
• Economic Stimulus Packages - do they work? - Gordon Brown is hoping they will, but, we might need to wait until the end of 2009, such is the intensity of the current time
  
• Desperate measures for desperate times - The MPC get radical but is it too little too late?
  

Other Economic Essays

• Simple Guide To recessions - The recession index has gone through the roof
  
• The Economics of Fear - the role of fear and confidence in economics
• Can A Recession really be a good thing? - Feb 2008 - With the economy moving into recession, it was surprising how many were talking of the benefits of recessions
• The problem of Obesity
• Should the government cut tax on petrol?
• Mistakes of Politicians - Feb 2008 - The essay is probably a little on the short side
• Why Economics is called the dismal science
• General Motors Bailout

Credit Crunch 2008

• Essays on Credit Crunch
  
• Who is to Blame for credit crunch?
• The Free market fails
• Books on Credit Crunch
• Learning from Credit Crunch
• Iceland Economy

“It’s not based on any particular data point, we just wanted to choose a really large number.” —- a Treasury Department spokeswoman explaining how the $700 billion number was chosen for the initial bailout, quoted on Forbes.com Sept. 23

“The fundamentals of America’s economy are strong.” —- McCain, in an interview with Bloomberg TV, April 17

"He is like some sherry-crazed old dowager who has lost the family silver at roulette, and who now decides to double up by betting the house as well." - London Mayor Boris Johnson on prime minister Gordon Brown.

“Cash for trash.” —- Paul Krugman discussing the financial bailout, New York Times, Sept. 22.

"We not only saved the world..." - Gordon Brown in the House of Commons on his banking plan. The rest of the sentence was drowned out by Tory jeers.

"Wall Street got drunk and now it's got a hangover. And the question is how long will it sober up and not try to do those fancy financial instruments?" - US president George Bush's pithy analysis of America's financial services meltdown.

“There are no atheists in foxholes and there are no libertarians in financial crises.” —- Krugman, in an interview with Bill Maher on HBO’s “Real Time,” broadcast Sept. 19. Paul Krugman later said it was not his original quote but from Jeff Frankel (other people's wit)

"It's almost like seeing a guy show up at the soup kitchen in high hat and tuxedo. It kind of makes you a little bit suspicious." - Congressman Gary Ackerman, on the big three carmakers arriving in a private jet to beg the government for financial aid.

“Anyone who says we’re in a recession, or heading into one —- especially the worst one since the Great Depression —- is making up his own private definition of “recession.” —- commentator Donald Luskin, the day before Lehman Brothers filed for bankruptcy, The Washington Post, Sept. 14

We believe that with our strong capital base and liquidity, we have a strategic advantage to capture the many opportunities arising in the midst of this market turbulence." (February 6, 2008 - CFO Kelleher of Morgan Stanley at the Credit Suisse Group Financial Services Forum) - Morgan Stanley later posted record losses

"In today's regulatory environment, it's virtually impossible to violate rules ... but it's impossible for a violation to go undetected, certainly not for a considerable period of time." - Bernard Maddoff

On the subject of large swings in the market: "Take my word for it, for the most part you can ignore those moves."- Bernard Maddoff

Time lags play an important role in the effectiveness of economic policy. It is estimated that interest rate cuts can take upto 18 months to have their full effect. This means that the rate cuts of the past few months, may not have their full effect until mid 2010. Of course, by then the economy may have recovered from the recession. It is the same with fiscal policy, if the government plans to increase spending e.g. bring spending plans forward it can still take several months for the fiscal stimulus to kick in.

Why is there A Time Lag for interest rate cuts?

• Fixed rate mortgages. Many on fixed rate mortgages are effectively insulated from the current rate cuts. When they come to remortgage in 1-2 years time, they may be able to remortgage to a lower rate. But, there disposable income is not being influenced by current rate cuts.
• Confidence. Just because rates are lower doesn't mean firms rush out to invest in building new factories. They will give a greater weighting to growth and expectations of future growth. Therefore, it will take time before they respond to lower rates by deciding to invest.
• Banks not passing rate cut on. Banks are often slow to pass the rate cuts on to consumers. Also, they may not pass the full rate cut on anyway.
• Effect of depreciation. Lower rates have cause the Pound to fall. A lower value of the pound should make UK exports cheaper. In the short term, demand is usually inelastic. But, over time, demand will become more elastic and the exchange rate effect will be greater.
  

Problems of Time Lags

• The problem with time lags is that it makes any attempts at reflating the economy less effective. The UK economy is in recession - the Bank has cut interest rates and the government has cut taxes. However, if they don't have any real effect for 9-12 months, it means the recession will last for a long time. Unemployment will rise and there is nothing which can be done about it.
• The problem is that we now be facing the impact of the decision to raise rates from 12-18 months ago.
• The other danger is that the government may go too far in reflating the economy, so in 12 months time we could face the prospect of inflationary pressure because of the current expansion. I don't really think inflation is a problem at the moment, but, it has often been a criticism levelled at fiscal policy.
• One analogy of fiscal policy is that it is like driving a car, where you can only look out of the back window (economists can only see the past not the future)
• Then when you try to steer the car, it takes 5 minutes (time Lag) for the steering wheel to change the direction of the car. Therefore, for a left handed turn you can end up moving the car to the right and therefore crash.

In the US, 3 month Treasury Bills have started attracting a negative interest rate. What this means is that people are willing to pay the US government the privilege of holding their cash. It reflects the deep concern that people have about saving in private banks. It is examples such as this which caused Warren Buffet to quip that mattresses could be the best thing to invest in 2009 - because people will want mattresses to horde their cash in.

The rush for cash is one reason why the dollar has been unexpectedly strong this year. The dollar is widely looked upon as an alternative currency, so when people demand more cash, they often demand more dollars. Therefore, despite 0% interest rates in the US, the dollar has been relatively strong.

The Effect of 0% Interest rates

• Monetary Policy becomes ineffective. Generally, you can't cut interest rates lower than 0%. It means that with 0% interest rates, the MPC are not able to cut interest rates any further to boost the economy. Conventional monetary policy has reached the end of its potential.
• Unconventional Monetary Policy. If the economy experiences deflation and interest rates are 0%, then the monetary authorities may be forced to take unusual steps such as increasing the money supply. To highlight the unconventional nature of 'quantitative easing' Ben Bernacke highlighted the idea of dropping money from a helicopter. The point is that increasing the money supply may be necessary to overcome deflation and deflationary expectations.
• Carry Trade. When Japan had 0% interest rates and other countries had significantly higher interest rates, there was an incentive to take part in the Yen Carry Trade. This involved borrowing from Japanese banks at 0% and then saving in other countries. If exchange rates were stable, you could make an easy profit. - Borrow at -0% save at 4%. However, the fall in interest rates is a global phenomenon, it won't just be one country which is affected. However, it will be interesting to see whether the ECB are willing to cut rates to 0% - given their anti inflationary bias.
• Base Rates and Saving Rates. If bank rates fell to 0%, there could be a big fall in bank savings. But, although, base rates may be 0%. Banks are likely to keep saving and lending rates above 0%

Real Interest rates.

The impact of 0% interest rates will depend on the inflation rate. If inflation stays positive e.g. 2%, then we will have negative real interest rates. This will be bad for savers. If we have deflation, then real interest rates will be high, although this will be good for savers it will be very damaging for the economy.

• Interest rates explained

The US have cut interest rates from 1% to between 0 and 0.25%. This is the lowest rate for interest rates in the US. However, there was greater interest in the Fed's plan of quantitative easing - buying assets such as Treasury bonds and mortgage backed securities to effectively increase the money supply.

Many feel that the interest rate cut will do little to boost spending, borrowing and investment. (rates on short term treasury bills are 0% already) However, the willingness to increase the money supply through quantitative easing has been heralded by some as a bold move to deal with the threat of deflation.

As mentioned, the US has already been increasing the monetary base this year. With the velocity of circulation falling, this has not increased inflation (see: Money supply and inflation in US). In fact consumer prices fell last two months.

Quantitative easing is modern day version of printing money. What the Fed will do is buy Treasury bonds and mortgage backed securities, this effectively increases the money supply and keeps interest rates on bonds low.

Quantitative Easing and the Risk of Hyperinflation.

Some economists, argue that a dramatic increase in the money supply that the Fed is proposing could easily lead to inflation and possibly hyperinflation.

At the moment, the increased money supply is not causing inflation because the velocity of circulation is falling. However, if there was a sudden rise in the velocity of circulation, then combined with increase in monetary base, we would see rapid inflation - easily leading to hyperinflation.

Could this happen?

Bond Bubble?

At the moment, there is great appetite for buying US treasury bonds - even though interest rates are close to 0%. However, if investors felt that bonds were not as secure as they hoped, then people would rush to sell their bonds and buy other assets such as commodities this would cause a rise in the money supply and devaluation in the dollar. The risk comes from the rising level of US government debt. If the US lose its credit worthiness, people would no longer want to hold US securities at 0% interest rates. They would sell causing depreciation in dollar and increase money supply. (see: Bond bubble?)

At the moment, the risk of deflation is greater than inflation. Increasing the money supply, is less painful than further government borrowing. But, the Fed will be walking a tightrope - print too little money, the US could be sucked into a deflationary trap; print too much and it could cause inflation.

However, I agree with Greg Mankiw, that a moderate rate of inflation would be a good move for the US economy in its present state

Since the economic situation is all doom and gloom, let us take a break from the current economic crisis and remember a previous economic crisis.

The exchange rate mechanism was designed as a precursor to joining the Euro. The aim was to keep exchange rates stable; it was hoped this would

• Keep inflation low
• Provide stability for exporters encouraging trade
• Enable countries to make the leap to joining the Euro.

In the late 1980s, the chancellor, Nigel Lawson was keen to join the ERM. But, Mrs Thatcher with her eurosceptic views wanted to stay out. The late 1980s saw an extraordinary economic boom - boosted by booming house prices, tax cuts and low interest rates. Growth reached record levels of 5-6% a year. Enthusiastic government ministers talked of an economic miracle - hoping Government policies had enabled, at long last, to catch up with other countries like Germany.

However, this miracle was an illusion. High growth was unsustainable and led to inflation. With inflation of 10%, Nigel Lawson was able to convince Mrs Thatcher that the UK would benefit from joining the ERM to help reduce inflation.

Therefore, the UK joined in October 1990. at a rate of DM 2.95 to the Pound

However, the problem was that the economic situation was declining quickly. The UK was sliding into recession. High inflation and deteriorating economic activity was making the Pound less attractive. Therefore, the Pound kept falling to its lower limit in the ERM. Therefore, the government was bound to protect this value of the Pound by:

• Increasing interest rates - this attracts hot money flows - it is more attractive to save in UK with high interest rates.
• Buying pounds with foreign exchange reserves.

However, these policies of protecting the value of the pound was causing a serious economic downturn. High interest rates particularly hit the housing market. With rising house prices, many had taken out large mortgages to get on the property ladder (sound familiar?) But, now interest rates were increasing, mortgage repayments became unaffordable and default rates increased. Combined with rising unemployment from the recession, the housing market saw a dramatic fall in prices that was to last 4 years.

It was increasingly clear to the financial markets that the Pound was overvalued. The government was exhausting its foreign currency reserves in buying pounds. But, more problematically, the high interest rates was causing a serious recession and misery for homeowners.

Financial speculators like George Soros predicted the Pound was doomed, so they were keen to sell their pounds to the British government.(It is said George Soros made £1 billion out of the UK government)

It became a question of pride for Ministers, with Norman Lamont and John Major pledging to keep the UK in the ERM, seemingly at all costs.

For a long time, the British government fought a losing battle. But, the foreign currency reserves of the British government were no match for the trillions of Pound Sterling traded on the foreign currency and the pound kept sliding. It is estimated that the Treasury used £27billion of foreign currency reserves trying to prop up the Pound. The Treasury estimated the final cost to the taxpayer was estimated at £3.4billion

On one desperate day - Wednesday 16th September, the UK government increased interest rates from 12% to 15%. In theory, these high interest rates should attract hot money flows. But, the market saw it for what it was - a measure of desperation. The market knew these were fantasy interest rates which couldn't be maintained, the sell off continued and eventually, the government caved into the inevitable and left the ERM. The Pound fell 15%, interest rates were cut, and the economy was able to recover.

It is a classic example, of failed government policy. If the UK had joined the ERM at a high level at the start of the boom, the anti inflationary impact would have helped moderate the boom, keep inflation low and prevent a painful readjustment. But, they joined at the wrong rate at the wrong time. Trying to keep the Pound artificially high caused a recession, deeper than any of our competitors. The artificially high exchange rate just attracted financial speculators who saw the British government as a source of easy profit.

On leaving the ERM, the UK economy soon recovered, but, it left painful scars and played a key role in keeping the UK out of the Euro. It also shows the mistake of targeting inflation through an intermediary such as the exchange rate. As a consequence of this episode, the government gave the Bank a direct inflation target of 2.5%. They also paved the way to given the Bank independence in 1997. The hope was that an independent bank would avoid the excesses of the Lawson boom and bust of the 1980s.

Related

• UK Recession of 1991-92
• UK Crashes out of ERM in 1992 at BBC
• "Unemployment is A Price well Worth Paying for lower inflation" - Norman Lamont commenting on his own policies

I've never read Charles Dickens, but, I enjoyed watching the BBC series Little Dorrit. One sub plot was about a super rich Mr Merdle who was well renowned as being the peerless investor of his time. Mr Merdle never had to offer a sales pitch to anyone. People merely begged his indulgence to be taken into his financial scheme, which year after year gave unimaginably impressive returns. As the series progressed, the impending collapse of Mr Merdle finance schemes became blindingly obvious to all - except the main characters who were taken in by the prospect of easy money.

A couple of days after the last episode was screened, we find we have our modern day - real life Mr Merdle - Bernard Madoff - Feted by the Rich - Madoff was schemer supreme at Independent.

The sheer scale, size of the $50 pyramid scheme beggars belief. It is not without irony that Bernard Madoff originated in Florida. Many of those worst hit by the scam are his Florida neighbours - who have been frantically selling their multi million pound houses (in an already stagnant market). It is of course in Florida that the misselling of subprime mortgages was the most prominent, leading to the current credit crunch and financial turmoil

What Florida has given to the world in the past couple of years:

1. A very dubious election victory for George Bush by a few hundred 'dimpled chads' - Giving the world, the most contentious US president for many decades.
   
2. Subprime mortgage crisis which continues to cause misery.
   
3. Bernard Madoff $50bn pyramid scheme.

In a previous post - The difference between economists and non economists, I gave the impression economists are a paragon of virtue, rationality and common sense amidst a sea of ignorance, superstition and irrationality. Some have suggested the post is condescending and patronising. They are probably right, but, sometimes it is good to state a case in strong terms, to make people think. However, I feel there is a need to redress the balance and point out the many mistakes / limitations of economists.

Economics is difficult

I think it was Keynes who said economics is very difficult and many people underestimate how difficult it is. In maths 2+2 always =4. But, in economics it usually depends on countless variables almost too difficult to take into account. To give one example, the link between the Money supply and inflation. The quantity theory of money MV=PY suggests there is a correlation between the money supply and inflation. (as most non economists would tell you - if you print money you will cause inflation) But, in practise the growth of the money supply is influenced by so many variables such as technological change, velocity of circulation and consumer behaviour that M3 growth statistics became almost meaningless. - MV=PY is great in theory but in practise it is difficult to make anything out of it. (money supply and inflation)

Forecasting the Future

It is difficult to forecast the future; yet in economic policy making, it becomes important . Go back to May 2007 and how many economists were predicting a fall in UK house prices of 25% and the deepest recession since the war? I wasn't and certainly not the treasury economists, who were predicting stable growth of 2% and a reduction in the government's borrowing. Of course, there were people predicting a house price collapse and they have been proved right. (Though some of them started predicting a house price collapse back in 2000.)

Difficult in Knowing where you are.

One of the great challenges is knowing the current state of the economy. For example, China's growth and unemployment figures are always viewed with suspicion. There is great debate about what the US inflation rate is - it depends which model you use. Recently, the US GDP statistics were revised meaning that the economy was in recession much earlier than previously thought. How can you make good policy when you don't even know what happened in the past? - let alone predict the future.

Using Old Models

In a way, this recession is unusual in that it wasn't preceded by an inflationary boom. The government felt that as long as inflation is under control, the economy must be sustainable. However, the mistake was to ignore an asset and lending bubble. The problem is that it is not sufficient to rely on previous experiences. As the economy develops old models become less relevant.

Ideology.

A good economist would be free from ideology and have a willingness to revise theory in light of empirical evidence that doesn't match upto their beliefs or expectations. However, in practise many dislike evidence which doesn't agree with their point of view. For example, some economists place great faith in the virtues of the free market and therefore take a lazy attitude in assuming free markets will always lead to increase economic welfare. The problem is that free markets can often be beneficial. But, at the same time, there will always be exceptions; you can't make generalisations that free markets are always best nor can you make generalisations that free markets are always wrong. It is necessary to evaluate each on a case by case basis.

Another example of ideological economics could be the assumption that if privatisation works in one country it must be good for other countries too. Free trade is another example. Most economists will tell you free trade is beneficial. But, this doesn't necessarily mean developing countries should always stick to the free trade mantra. - There can be exceptions to every rules, for example the infant industry argument.

• Financial mistakes of the Naughty naughties

• Usually, recessions follow a boom - a period of rising inflation and unsustainable growth. For example, you can see significant recession in 1974 after the Barber boom. The last recession 1991, came after the prolonged Lawson boom of the late 1980s.

• Yet, this recession came despite any obvious period of unsustainable growth and high inflation. Growth was rarely above the long run trend rate and inflation was more or less on target, (apart from a rather misleading temporary cost push inflation from rising oil prices.)

Yet, although on the surface, the economy was a paragon of stability, if we dig deeper we can see an element of boom and bust.

Boom and Bust in Housing Market.

House prices tripled during the decade 1996-2007. House prices are now falling sharply. The impact of the housing market on the economy should not be understated. Rising prices encourage a fall in the savings ratio; people remortgage and are more willing to spend on credit.
Falling house prices cause a collapse in confidence and willingness to spend.

Current account deficit


The UK saw a rise in the current account deficit. This is indicative of suppressed inflationary pressure. As the domestic economy achieves shortages, people respond by buying imports. A rising current account deficit implies a greater % of GDP is devoted to consumption. The economy is consuming more than it is producing.

Boom and Bust in Credit.

Tied closely to the state of the housing market is the availability of finance. Rising house prices give banks incentives to make credit freely available. Falling house prices cause a retrenchment as lenders protect themselves against negative equity. This natural credit cycle was exacerbated by a rise in new types of bank lending. In particular, banks were more willing to borrow on short term credit markets in order to lend mortgages. With the case of Northern Rock over 70% of their mortgage lending was financed through short term lending on money markets. When credit markets suffered the credit crunch - they were stuck.

Recession Without Boom

One of the lessons from this current recession is the need to regulate different aspects of the economy and finance markets. In other words it isn't sufficient just to target inflation. Economic growth can become unbalanced - even if growth and inflation look good.

Of course, some countries really are experiencing recession without having a boom. Germany and Japan are both in recession, but their economies displayed little or no sign of boom before the bust. It also shows that we are facing a global downturn which is affecting all major economies.

Source of data: Speech by Andrew Sentance, Bank of England - THE CURRENT DOWNTURN – A BUST WITHOUT A BOOM? Tuesday 9th December 2008

(updated: December 2008 the exchange rate has edged towards 1 Euro to 1 Pound)

Readers Question: I read a lot about the Dollar/Pound relationship but I want to know what the forecast is going to be for Euro/Pound. The Pound has lost again against the Euro and I don’t understand why as the UK economy is not doing too badly. Is the Pound going to be even less worth against the Euro say in three months? What is the factor that drives the value of the Pound down against the Euro?

Graph showing Value of Euro to Pound 1999-2008

Reasons Why the Pound has Devalued against the Euro

1. UK Economy in steepest recession. The UK economy experienced negative growth in Q3 2008 and is now facing steepest recession since Second World War. (industrial output collapses) Because of sharp slowdown interest rates have fallen sharply from 5.25% to 2% (and will probably go lower)
   Graph UK Interest rates
   
   
   
   Lower interest rates are very important for weakening a currency. Lower UK interest rates make it less attractive to buy Sterling and save money in the UK. Therefore, there are less hot money flows and a weaker value of Pound.
2. Housing Market. The UK Housing Market plays a crucial role in determining consumer confidence, spending and economic growth. Recently the rate of house price falls has accelerated and some people predict house price falls of upto 30%. If house prices fell by another 15%, growth would slow down alot in the coming months. Again, this would lead to lower interest rates and a lower exchange rate. The markets are anticipating lower interest rates in the UK.
3. Credit Crisis. The UK is heavily exposed to the credit crisis because mortgage lending accounts for a high % of disposable income. Mortgage lending is more important in the UK than the Eurozone where mortgage payments account for a smaller % of disposable income. With less mortgages becoming available, demand for housing is falling. Also those with existing mortgages are seeing the cost of remortgaging increase. This is putting pressure on the Bank of England to reduce base rates to compensate for the increased bank rates. As they explained the recent interest rate cut:
   
   "The disruption in financial markets could lead to a slowdown in the economy that was sufficiently sharp to pull inflation below the target."
   
   
4. The Euro is slowly becoming the World's Reserve Currency. With the Dollar in long term decline (and with good reason) government's and investment bankers are looking for an alternative to holding currency in the dollar; the main alternative is the Euro.
   However, it is worth noting the Pound has recently been weak against the Dollar as well, suggesting problems facing Sterling in particular.
5. UK Current account deficit. Relative to the EU, the UK is running a current account deficit, which puts downward pressure on sterling because of the outflow of foreign currency.
6. Large Rise in Government Borrowing for 2009. With government bailouts, fiscal expansion and tax cuts, government borrowing will be over £115bn or 8% of GDP. This causes lower confidence in the UK economy to pay off debt (though UK public sector debt is still lower than many of our European counterparts)
   

Predictions for Pound vs Euro in Next Few Months.

Now that the pound has fallen to £1 = 1 Euro, it is hard to see it falling much further. Some foreign currency dealers are still pessimistic about the Pound, so in the short term this may continue to push the pound lower. But, it should not be forgotten that the Eurozone is also in recession, so we are likely to see lower EU interest rates in 2009

The strength of the Euro is also causing problems for EU exporters.

Conclusion

The Pound has fallen on the back of depressing economic statistics. The whole Global economy is likely to experience recession, but, the UK recession has been deeper than most. Against this backdrop the pound has been weaker.

Related:

• UK Economy 2009
  
• Germany and UK economies
• Is the Pound Collapsing
  
• Falling value of Sterling
• What causes a currency collapse?
  

Reference
Picture from : Guardian - Pound falls to record low

Today, I just feel like having a bit of a rant. It's interesting that when Economics hits your own pocket - you start to have a slightly different view on issues.

Firstly my mortgage company Standard Life have announced that since base rates have been cut by 2.5% since November they will cut their standard rate by 0.8%. That means my mortgage payments will fall much less than I had hoped. They cite:

"There have been significant and unprecedented changes within the economy and mortgage market in recent months. As a result, we have adjusted our standard variable rate accordingly and with a view to offering a sustainable rate in the long-term...."

What they really mean - the current volatility gives us an excellent opportunity to increase our profit margins. Thanks for your continued custom. :)

Well, there is an argument that banks need to encourage savings and therefore they shouldn't be forced to cut rates. But, I think 80 basis points out of 250 is still a bit greedy.

Direct Debit and a Clever Way for Firms to increase Cash Flow

Secondly, I pay electric and gas by direct debit. I always seem to be in credit to them (pay more than I use). My balance is currently in credit by £58. Anyway, they say that next year the direct debit will increase from £53 a month to £71 a month - stating something about seasonally adjusted consumption rates compared to average consumption levels.
I could argue with them and try to negotiate a lower monthly rate, but, the opportunity cost of wasted time talking to call centres means there is a strong incentive to ignore it.

I think it was Gary Linekar who said - "Football is a game of two halves, between 2 sides of 11 men, and at the end of the game Germany win on penalties."

Now, the game has switched to economics, with the German Finance minister castigating Gordon Brown for his profligacy in trying to 'spend his way out of a recession.' Who will win the battle of economics?

If past history is anything is to go by, it won't need a penalty shoot out - German growth has far outstripped UK growth since the Second World War.

The current situation is interesting because both Germany and the UK are in recession - but for different reasons. (see: German Economy in Recession)

The irony is that the recent budget of the UK (tax cuts, spending increases, higher government borrowing) would have been more suitable and desirable for the Germany economy.

Both UK and German economies have imbalances. Germany's imbalances is that they are relying too much on exports. Domestic saving is high and domestic consumption low. With high levels of domestic savings, it would make sense to encourage consumers to spend, at least during the recession. Furthermore, because Germany currently has a balanced budget (something Gordon Brown could only dream of) it gives them greater scope for borrowing during this downturn.

The Germans are in a relatively good position because:

• They aren't burdened with same levels of personal debt
• They don't have a boom and bust in housing market.
• Boosting domestic consumption would help Germany come out of recession, without causing unsustainable levels of consumer borrowing.

Therefore, in theory expansionary fiscal policy would be quite effective in Germany (probably more effective than in the UK, where consumers are likely to save tax cuts to pay off their onerous debts)

Paradox of Thrift.

People assume saving is good for the economy. Therefore an increase in savings will always help? But, the problem is you can have too much of a good thing - especially if it occurs at the wrong time.

If German saving levels were to continue increasing and domestic consumption falls then their recession will be deep. If they encourage German consumers to spend it will take some of the slack from falling exports and help the economy recover.

It is said you save for a rainy day. - The recession is the rainy day; to persist in balancing the budget and encouraging domestic savings would only aggravate the recession. Germany can and therefore should pursue expansionary fiscal policy. - Not necessarily in the same format as the UK, there are better ways to boost Aggregate Demand than cutting VAT by 2.5%

Fear of Inflation

Everyone knows the social upheaval Germany suffered because of the hyper inflation of the 1920s. Ever since then, Germans have had an understandable feared hyper-inflation. But it is one thing to prudently avoid excess inflation, it is another thing to have a paranoid fear of something with no likelihood of occurring. In a recession, inflation is not the concern. ( A previous post shows how in a recession how much you may need to increase the monetary base sufficiently to prevent deflation).

Germany should not be fearing the hyper-inflation of the 1920s, they should be fearing the deflationary decade of Japan in the 1990s and 2000s.

So maybe Germany can learn something from Gordon Brown after all - it's time for the Germans to lighten up - throw away their classical economic textbooks and go dig some holes in the ground a la Keynes. Bon Chance!

Of course, after the recession is over, the UK has many things to learn from Germany not least:

• stability in the Housing market
• encouraging domestic savings
• Having a strong manufacturing sector
• Fiscal responsibility over the long term.

GDP in Germany contracted 0.5% in the third quarter, following a 0.4% drop in the second, which corresponds to the official definition of a technical recession – two consecutive reductions in GDP. Unlike the UK, the Germany economy is in recession despite:

• No boom and bust in house prices
• No credit boom
• Relative High level of personal savings and low borrowing. (German savings ratio is 11.7% and forecast to rise - UK's savings ratio was 1% this summer)
  
• Government balancing its budget.

It just shows that the causes of recessions can be more complicated than many may imagine. It is somewhat fashionable to say 'excess borrowing caused the recession ' Whilst this is true to a large extent, the experience of Japan, Germany and China show that high savings, prudent government spending and even avoiding boom and bust in housing market is no guarantee for avoiding a recession.

• Germany is going into recession mainly because exports form a large % of GDP and therefore firms are being affected by the global slowdown.
• Germany is also being affected by the relative strength of the Euro, which make exports less competitive.
• The Government's balanced budget is all very admirable. But, in a recession, the fixation with fiscal responsibility could aggravate a recession, when they could do quite a lot to get out of the recession.
• Germany is also being affected by the global credit crunch. It doesn't matter it started in US. It's just as difficult to get credit in Germany and this is causing a fall in investment.

German Criticisms of UK Policy

Peer Steinbrück, the German Finance Minister, recently described Britain’s switch from financial prudence to heavy borrowing as crass and breath-taking.

Cutting VAT is not the best way to stimulate the economy. But, rather than criticise UK policy; he should focus on taking the necessary steps to deal with the German recession. Their fixation with responsible borrowing in the times of a recession is a throwback to the classical economics of the 1930s which aggravated the Great Depression.

His comments suggest he misunderstands the purpose of cyclical fiscal policy.

With a savings ratio of 11.7% and rising, Germany would benefit from encouraging consumer spending. Their economy has become too reliant on exports. This is fine when the global economy is doing well. But, now the global economy faces the worst recession since the war, Germany could see a sharp contraction in manufacturing output.

German unemployment is under 3 million but, it could rise to 5 million - the figure seen in the last German recession. The prudence of balancing a budget will mean little to those 5 million unemployed.

• Germans drink their beer despite recession - Guardian

Recently, I wrote about what could cause a collapse in currencies. Does this apply to the Pound?

• Firstly, UK inflation is low and is likely to fall.
• The UK has a reasonably large current account deficit (about 3.5% of GDP) but it is not unmanageable. The UK doesn't have a balance of payments crisis

So the two fundamental reasons for a sharp collapse in the currency are not there.

The Pound is steadily falling because:

• Previously it was punching above its weight - you could say it was overvalued at least against the dollar. So its current decline is in a way returning to 1996 levels when the Pound was very weak against the D-Mark
• Large Cuts in UK interest rates which make it less attractive to save in UK
• UK recession is deeper than anywhere else so interest rates could keep falling to 0%.
• Speculation - Investors are making alot of money out of the falling pound; with shares in the doldrums betting on exchange rates is one of the few ways to try and make a decent return. There is an element that the weakness of the pound is feeding on itself.

Some currency traders still think the Pound could fall further, but, in 2009 I wouldn't be surprised to see the Pound recover some of its lost ground or at least stabilise.

True, the UK recession is deeper than elsewhere, but rates in Europe are likely to keep falling as Germany and France go deeper into recession as well.

People point to high levels of government borrowing in the UK. But, high levels of borrowing only have a limited impact on the exchange rate. Furthermore, UK public sector debt is not any worse than other OECD economies.

Is it a problem that the Pound is falling?

Not really. The usual inflationary impact of a falling exchange rate is muted because of the recession. It will provide some help to our beleaguered exporters.

I have seen many blogs point to the huge increase in the US monetary base and conclude that the US will soon experience hyperinflation and a collapse in the value of the dollar. The graph for US money supply looks pretty dramatic. Never before have the Federal Reserve been increasing the monetary base so rapidly. This year, the growth of M2 has reached double figures. So why did the US see a FALL in prices last month?



The link between Money Supply, inflation and National Output has become increasingly tenuous over recent years

Velocity of Circulation.

Money Supply doesn't just depend on the amount of money printed (monetary base). It depends on the velocity of circulation - how many times it changes hand. The problem is that the velocity of circulation is falling faster than the Fed can increase the monetary base. The velocity of circulation is falling because of the recession - rising unemployment, falling investment and falling consumption - People are hoarding cash and not spending it.

This is why many economists argue the increase in the monetary base is absolutely necessary to avoid a deflationary spiral. See: What Would Keynes do at Economists view

Financial Changes

Measuring the money supply is difficult because of evolution in the financial sector mean measures of the money supply are always changing. The Federal Reserve of bank of New York outline various reasons why money supply statistics are misleading to the state of the economy

Does this mean we can publish as much Money as we Want?

No, if the money supply does increase too much, then it will cause inflation. The problem is that it is quite difficult to actually know how much the money supply needs to increase. But, with the US economy facing most serious recession for a long time, the Fed are right to be more concerned about potential of deflation than inflation.

There is a danger the Fed could overshoot and create too much, but, at the moment this is not happening. Inflation is the least of our worries at the moment.

• What is more likely inflation or deflation?

It is rather ironic, that officially the UK is not in a recession. (growth was 0% in Q2, fell by 0.6% in Q3). An official recession requires 2 consecutive quarters of negative growth - Q2 doesn't count since it was 0%)

Anyway, without a shadow of a doubt, Q4 will confirm what is already obvious - that the UK is in a steep recession and it could prove the worst recession since the Second World War.

Recent data from the Manufacturing sector gives more grim news. Industrial production (manufacturing and mining) fell 1.7% in October. This is a huge monthly fall and gives the biggest annual fall since 1991. Even though industrial output only accounts for 18% of total GDP. It is likely to lead to a large fall in GDP in Q4.

Graph of Manufacturing Output


What this shows:

• Fall in the Value of the Pound has given little benefit to exporters.
• Interest rates are likely to fall further in 2009
• The downturn in the past few months has been much sharper than anticipated.
• Recently producer prices fell - another indicator of weak demand and an indicator of future deflation
  

When will the downturn end?

Cuts in interest rates and expansionary fiscal policy will help; but there is always a time lag. Interest rate cuts can take upto 18 months to have an effect. It appears there is a powerful negative momentum in the economy creating a negative downward multiplier effect.

• UK Economy

This year we have witnessed many currency's suddenly collapse. Iceland, Argentina, Hungary, Ukraine and others have all seen a sharp fall in the value of their currency. What causes this? and are other economies at risk?

Causes of Currency Collapse

1. Inflation.

Inflation reduces the value of money. If there is rampant inflation, then a currency will depreciate in value. For example, the hyper inflation of Zimbabwe is well documented. Inflation makes Zimbabwe currency worth less, so people will try to exchange Zimbabwe Rand for other currencies which will hold its value.
What causes inflation?

• Printing Money. Note printing money doesn't always cause inflation. It will occur when the money supply is increased faster than the growth of real output.
• Note: the link between printing money and causing inflation is not straightforward. The money supply doesn't just depend on the amount the government prints. The US has been increasing the monetary base substantially, but, as of yet, it hasn't led to inflation because of other factors influencing inflation.
• Large National Debt. To finance large national debts, governments often print money and this can cause inflation. This was the case in Zimbabwe. But, national debt doesn't have to cause inflation. Japan borrowed 195% of GDP, yet have very low inflation.

2. Current Account Deficit

A current account deficit means that a country imports more goods and services than it exports. To finance this deficit, they will require a surplus on the financial / Capital account.

• For example, at the start of this year, Iceland had a current account deficit of around 7% of GDP. They were able to finance this deficit by attracting capital flows.
• - To give one example, their banks had high interest rates which attracted UK councils to save their money in Icelandic banks.
• Because they were getting capital inflows from abroad, the Icelandic economy could continue to finance its current account deficit.
• However, the problem comes when you can no longer finance this deficit - when you can no longer attract capital flows. The global credit crisis meant Icelandic banks were losing money. Therefore, people started to withdraw their savings from Iceland.
• The capital flows were drying up, this will cause a depreciation in the exchange rate. Basically there is more money leaving Iceland coming in. This will be reflected by the fall in the exchange rate.

Another example, this year, Ukraine had a current account deficit of 6.7% of GDP, but, the IMF says next year it will be able to attract less capital flows, therefore, the maximum current account deficit it could run is 2%. Therefore, the Ukraine currency will devalue to reflect this.

3. Collapse of Confidence

If there is a collapse of confidence in an economy or financial sector, this will lead to an outflow of currency as people don't want to risk losing their currency. Therefore, this causes an outflow of capital and a depreciation in the exchange rate. Collapse in confidence can be due to political or economic factors.

4. Lower Growth and lower interest rates.

Lower rates make it less attractive to save in a country and therefore, there will be a modest depreciation. Lower rates don't usually cause a collapse in a currency, but, they will make the currency less attractive.

5. Price of Commodities

If an economy depends on exports of raw materials, a fall in the price of this raw material can cause a a fall in export revenue and a depreciation in the exchange rate. E.g. Ukraine has suffered from a fall in price of steel.

• Will US Dollar collapse?
• Understanding exchange Rates
  

Many people look to the current recession as an inevitable consequence of several years of decadent borrowing. It's like if you drink too much you 'deserve' a hangover. So the recession is often seen as a kind of a karmic punishment for our extravagance, asset bubble and irrationality.

Yet, the picture is not quite as straightforward. Both Japan and Germany are in recession. Yet, they have had no extravagant boom only a mountain of personal saving, large current account surpluses and in Germany's case a government with a balanced budget. Although, the cause of this current crisis can be traced back to irresponsible lending in the US mortgage sector, it seems that high levels of saving are no protection against recessions.

Anyway are recessions Avoidable?

1. Natural Trade Cycle.

Most economists argue there is a natural trade cycle, which is hard to break. Growth is not constant but comes in peaks and troughs. In this case, recessions are hard to avoid. All we can do is minimise the downturn and prevent an excessive boom.

2. Correction for Booms

If we get an inflationary boom, a recession becomes an almost necessity. For example, the Lawson boom of the 1980s saw economic growth in the UK double our long run trend rate. But, this growth of 5% caused inflation and in reducing inflation we had a sharp slowdown.

3. Avoid Booms and you Avoid the Bust

The theory is that if you avoid an inflationary bubble, then you can avoid recessions. This is why Central Banks are told to target low inflation. If inflation stays low, we can avoid the boom and bust economic cycle. Up until 2006, there was a feeling that Central Banks had brought an end to the trade cycle. (see: When Greenspan was nearly God). Up until this year, the UK avoided a recession for 17 years.

4. Bubbles without Inflation

The feature of the last bubble is that it took a different form. Core inflation remained low. But, there was an asset bubble - house prices rose creating a positive wealth effect, high levels of borrowing, low savings and consumers living beyond their means. Therefore, when the asset bubble burst, it caused a strong downward movement on consumer spending. Therefore, the low inflation masked the underlying disequilibrium in the economy. Maybe if the asset bubble and mortgage defaults had been avoided and the recession would have been avoidable

5. Global Downturn.

The experience of Germany, Japan, China and other countries who rely on exports is that they become reliant on the global trade cycle. As the main economies go into recession, it inevitably spreads the recession to these countries. Even if you follow prudent policies and seek to reduce debt, a global recession will push your economy into recession as well. Maybe their mistake is to put too much emphasis on relying on exports.

• The main cause of this recession is the global credit crunch, which has been difficult for any country to avoid.

6. Efficiency.

It is sometimes argued recessions are necessary (even beneficial) to create greater efficiency and get rid of inefficient firms. I don't agree with this. Recessions are not necessary to create increased efficiency. Sometimes, recessions can cause good, efficient firms to go under due to cash flow problems.

7. Supply Side Shocks

One contributing factor behind the current recession was the oil price shock in early 2008. It led to interest rate being kept high. There is little governments can do to alter the cost push shock of rising oil prices. It is hard to deal with supply side shocks of this nature.

• Recessions

No, its not a graph showing the share price of Woolworths. It is UK interest rates, which have today fallen to a joint low of 2%. The UK rate cut is expected to be matched by cuts in the ECB interest rate soon.

Why Have Rates Fallen So Quickly?

• Recession much deeper than anticipated.
• All sectors of the economy are being affected.
• Previous rate cuts are not having the desired effect in boosting demand. Usually cutting rates by 0.5% would have a big effect in boosting spending. But, we are entering a phenomenon known as a liquidity trap where lower rates have only a limited impact in boosting spending and investment.
• Housing market in decline.
• Inflationary pressures have fallen away. People expect inflation to fall sharply in the near future.

What Will Be the Effect of the rate cut?

• People on variable mortgages and loans, will see a fall in repayment costs. (though many borrowers are unlikely to receive the full rate cut.- because banks are trying to encourage saving rather than borrowing)
• The Pound may continue to weaken against the dollar (In US interest rates are already very low) But, with ECB expected to cut rates by same amount, the rate cut will not worsen the Pound against the Euro.
• It is unlikely to stop the fall in house prices. It is very cheap to get a mortgage. But, mortgages are being rationed by requiring a high deposit (which most people don't have). Therefore, mortgage availability will remain weak.
  

Will Interest rates Be Cut to 0%?

It is possible because rate cuts are unlikely to cause any inflation since the economy is so weak. Basically, rate cuts are not having much effect, therefore, the bank is trying much bigger rate cuts than usual to stimulate the economy. If inflation falls towards 0%, then inflation is possible.

Are rate cuts better than Fiscal Policy?

Rate cuts will hopefully stimulate spending, without the government having to borrow more. The problem is that the government feels monetary policy alone is insufficient to stimulate the economy.

• Interest rates explained
• The case for lower rates
  

The current recession looks increasingly severe. As people talk more of depression economics rather than just a cyclical downturn, there is increased interest in Keynesian economics and whether this offers a solution

Video On Keynesian Economics



Keynesian economics has become important because it looks like Monetary policy is insufficient to return the economy to equilibrium. See: Impotence of monetary policy

Criticisms of Keynesianism (taken from youtube comments)


> When government spends more ppl have less to spend

Maybe in a boom, but in a recession resources are idle so the government is forcing resources to be used that previously wouldn't. The economic uncertainty means people are looking to save in bonds. Therefore, government borrowing is not curtailing private sector investment. See also: Crowding out

>If government borrows they can only borrow so much.

This is true to some extent, and it is a shame governments weren't more prudent in the boom years. But, it is quite possible for public sector debt in the UK to rise from 40% of GDP to 50 or even 60% of GDP. The good news is with low interest rates, the cost of financing debt is low.

> As well, if you accept that theory all it means is that the economy will go back into a recession when the government finally needs to pay off its debts.

No, if you increase tax rates during economic growth, you may slow down the rate of growth and avoid inflation, but, it doesn't have to cause another recession. For example, after big tax cuts in 2001, the US government should have reversed some of these tax cuts around 2003-05. This would have lessened the boom and reduced the deficit giving more room for manoeuvre in this recession. Fiscal policy is a two way policy. It's not just about boosting demand in a recession.

> 2) It will cause monetary inflation

Where's the inflation? People talk of inflation as being a problem, but, inflationary pressures are collapsing. US consumer prices fell last month. The real concern is deflation. Deflation can devastate the economy. This is why Japan failed to recover in the 90s and 00s - it refused to create inflationary expectations. In a great depression, you want to create a moderate inflation rate! This is why governments target inflation of 2% and not 0% or -2%. If you boost aggregate demand too much as the economy recovers then you can cause too much inflation. But, nearly all economists would agree it is far more dangerous to have a little deflation than a little inflation.

Vintage Keynesian Propaganda



- The best bit is probably the cow mooing to prove he is a cow. Anyway, an interesting angle on economics!



Two Different Economic Perspectives on Keynesian Economics


Paul Krugman - Deficits and Spending - One of the most articulate supporters of a Keynesian approach. Krugman argues government borrowing is necessary in present situation.

See also: Depression economics returns

David Smith - Only Spending Cuts will get us out of this black hole. David Smith argues that the increased government borrowing is the biggest problem. Many other economists share his opinion.


What's your opinion? - Do you support the Keynesian approach? or do you think expansionary fiscal policy will just make things worse?

Keynes

Readers Question: James from The Good Life Asks Can anyone explain to me the principle of sustainable economic growth on a planet with finite resources? I guess it is not a good career move for an economist to admit a limit to growth.

When economists talk of sustainable economic growth, they are usually thinking of low inflationary growth that avoids an economic boom and bust. For example, the Lawson boom of the 1980s saw growth of 5-6% a year, which was unsustainable; it caused inflation and shortly afterwards there was an economic recession. However, sustainability increasingly raises questions of environmental sustainability.

The first thing that springs to mind is the 'Dismal Prophecies of Malthus.'

Back in the nineteenth century Malthus saw a rising population and predicted the world would face food shortages because the population was rising, but, the available land wasn't.

Yet, Malthus failed to anticipate the rate of productivity growth. In other words, with better technology, better farming practices the output from land has increased substantially. Productivity increased so much, an economy like the UK only has 3% of its workforce employed in agriculture, compared to 90% plus.

This is the first aspect of growth. Economic growth, doesn't have to involve greater consumption of raw materials and more land. Better technology can enable higher output with the same amount of raw materials - or even less.

For example, transport and energy doesn't have to involve the use of non renewable resources. Economic growth combined with technological progress could mean our energy sources are provided by renewable energy. Computers and the internet have reduced costs for firms and enabled higher growth with less resources.

What Happens when we run out of oil and other raw materials?

At the moment, our economy is dependent on oil, at some time oil will run out and therefore prices will rise - will this bring an end to economic growth? Economists argue this will just provide incentives to develop alternative source of energy, even if this involves 10,000 windmills in every county. We will still be able to provide power, but, we will be forced to find alternative means that are sustainable.

Basically, this is the 'optimistic view'. Economic growth caused by increased productivity, and better technology can enable higher living standards and higher GDP without depleting the earth's resources. There is no reason why this growth cannot be sustainable forever.

However, Pessimistic View.

• True, Malthus was wrong, but, there are still limits to the productivity of land. For example, the productivity of agriculture becomes more difficult to increase - fertilisers have diminishing returns after a certain point. (let's leave out the GM Debate for the moment)
• External Costs of Growth. Combined with rising population, increased output is causing strain on the environment in terms of pollution and global warming. This could lead to catastrophic effects, which are hard for the market to predict and price.

• Economic growth is a combination of higher productivity and higher consumption of raw materials. True, economic growth is caused partly by better technology and increased productivity. But, growth also invariably leads to higher consumption of non renewable resources. Look at how China's economic growth has increased demand for non renewable resources.
• In theory, a shortage of raw materials provides incentives for the development of alternatives. But, the free market might provide a much less smooth transition than we would like. There is no guarantee renewable energy would be able to smoothly replace our dependence on fossil fuels.
• Population Growth. A rising population exacerbates all the problems of economic growth. The world population is fast rising; combined with bad management, environmental change, sections of the world's population face possible water shortages and other constraints to basic living standards.
  

Conclusion.

Even with finite resources, it is possible to have sustainable economic growth. Growth can occur without depleting more non renewable resources.

However, just because growth can theoretically occur with increased productivity / technology, doesn't mean there are not constraints on growth. We may find that the externalities of growth negatively affect living standards much more than we anticipate.

We also currently have a dependence on fossil fuels. If we are lucky we may have a smooth transition as they run out. But, it is quite likely that we will struggle to replace them as easily as we would like, this could place constraints on growth.

The problem is that because Malthus was so hopelessly wrong, it has become rather easy to criticise those who disagree with the inevitability of growth. However, environmental changes is occurring so fast, that maybe the future will be very different.

Growth can be sustainable, but, I disagree it is inevitable as some might suggest.

Related Essays

• How Can Economic growth help the environment?
  
• Does Economic Growth increase happiness?
  
• Economics - The Dismal Science

The government has reduced VAT from 17.5% to 15%, hoping to boost growth. Apparantely, shoppers are queuing up outside Curry's now their 50% sale has been increased to 52.5% sale.

"....2.5p may not seem like much," commented Mrs Cheapa, "but it adds up. I bought this plastic Tupperware set for £3.99 and saved 10p. Unfortunately the 10p fell out of my sari and down an uncovered drain on the pavement, but I still feel like I got a good deal."

...Property sales and mortgages are up a resounding 32% in one day. Royal Bank of Scotland, now primarily owned by the government, has led the way in accepting the 2.5p VAT savings from customers as sufficient down payments for mortgages.

When asked how the Royal Bank of Scotland can do such business without risking another sub-prime mortgage fiasco, its chairman, Sir Angus Spendthrift explained.

"It's simple. We teamed up with that no-frills Irish airline. If they can fly people around the world for 99p, then surely we can give them a home for an additional 2.5p." Sir Spendthrift added, "Their home may be in Albania, however, or wherever that fly-by-night airline lands these days....""

From: The spoof

WRITING in Slate magazine in 1997, Paul Krugman, an American economist, neatly captured the widespread belief in the omnipotence of the then-chairman of the Federal Reserve. “If you want a simple model for predicting the unemployment rate in the United States over the next few years, here it is: it will be what [Alan] Greenspan wants it to be, plus or minus a random error reflecting the fact that he is not quite God.” [Economist]

Since those heady days of the late 1990s, Alan Greenspan's reputation has nose dived (though Paul Krugman was awarded Nobel Prize for economics this year. (Ostensibly for his work on free trade, though his 8 years of bashing Bush, probably didn't hurt.). Anyway, one important issue which has been raised by the current economic crisis is the seeming impotence of Monetary policy in the current climate.


Paul Krugman was alluding to the fact in 'normal years' changing interest rates would have a powerful effect on influencing the economy - hence the quip it was easy to target a certain inflation or unemployment rate. In the past cutting rates would boost spending and investment, but, now it doesn't seem to be solving the problem.

Firstly it now seems that Monetary Policy in the Boom years was 'Too Effective'

They cut rates in 2001 to boost the economy and kept them low until 2004. This made mortgages very cheap and caused a boom in house prices. Because inflation remained on target, the Federal Reserve felt it was OK to ignore the boom in asset prices. - This was perhaps their great mistake.

Why Has Monetary Policy Become Less Effective? Why is the Federal Reserve increasingly impotent?

Falling Asset Prices.

When house prices are rising, cuts in interest rate make mortgages cheaper and encourage home ownership. With lower rates, people buy more houses causing rising house prices and this causes a positive wealth effect on consumer spending.
But, now house prices have a powerful momentum downwards, cuts in interest rates do little to make buying a house attractive. Mortgages may be cheaper. But:

1. It's difficult to get a mortgage anyway.
   
2. No one wants to buy when house prices are falling

Lower interest rates are helping to reduce the decline spending and investment, but, the interest rate cuts are being outweighed by the dramatic decline in house prices and fall in wealth of consumers.

Confidence.

When people have reasonable confidence, a cut in interest rate encourages people to spend. In the boom years people want to spend, and the rate cut makes it possible. However, in the current climate, confidence has collapsed. It may be cheap to borrow, but, people are asking - Surely borrowing got us into this problem, isn't time to pay off debts and try to save?

• In a way, people are making rational choices to save more. But, it makes monetary policy difficult. Cut rates by 1.5% and people largely ignore it. It is a classic liquidity trap.

Debt is Very High

Personal debt levels are very high. Therefore, people can't / won't borrow more, whatever the cost.

Cost and Quantity of Credit

In the boom years, credit was freely available. Various money markets meant it was easy for banks to borrow to lend to firms and consumers. Therefore, if demand for credit increased, the supply was there. The problem now is that the credit crunch has caused a shortage of credit. People may want to get a mortgage and banks, but, the banks just don't want to (or can't lend)
In the boom years, banks would try hard to be the most competitive mortgage lender. Now, they try hard to avoid being the cheapest as they get flooded with mortgage requests they can't cope with.

Robert Shiller, the Yale economist who predicted stock market falls and the US housing bust, has bad predictions for the UK Housing Market. He suggests house prices have further to fall. Guardian article

How To Avoid Boom and Bust in Housing Markets - This is something we need to think about for the future. Relying on monetary policy is not a solution. The solution may lay in reducing volatility of credit lending.

In a previous post on UK Public Finances, I was rather flippant about an IFS report, which I had only read a newspaper summary of. The fact this newspaper was the Daily Mail makes it even less forgiveable. Anyway, the IFS point to the high level of liabilities - future government spending. You can read IFS report here as a pdf

Crowding Out - Higher borrowing is said to occur crowding out. What is crowding out? and why it might not occur

Other readers questions

• Role of Food and inflation
• Role of Purchasing power parity and exchange rates
• Printing money in a recession
• State of Economy 2009
• Macro economic targets
  

It's easy to be wise after the event. But, it is important to be aware of the many mistakes that were made in creating the current financial crisis. These are some of the biggest problems of the past decade.

Extravagant Mortgages

• 100% Mortgages. The hope of 100% mortgages is that rising house prices would effectively create a deposit. Of course, when house prices are rising, this is fine. But, when house prices are falling it creates negative equity, meaning any home repossession leaves banks with large losses.
• Mortgages 6, 7 or even 8 Times salary
• Interest Only Mortgages with no repayment strategy
• Adjustable Rate Mortgages which promise low rates initially, but, become very expensive after 2 years. In America in particular, these ARM mortgages were sold often with little explanation of how mortgage costs would rise.
  

The Assumption of Permanently Rising House prices.

Housing boom and busts are common in both UK and other countries. Yet, in periods of rising house prices, people tend to become myopic forgetting prices can fall as well as rise. It is the assumption of rising house prices, which encouraged the extravagant mortgage lending.

Lack of Mortgage Regulation.

The worst example was the US subprime sector. Mortgages were approved for those who had no realistic ability to repay, even before interest rates increased and the economy declined.

Failure of Credit Ratings.

It is hard to imagine but bundles of subprime mortgage debts were given triple A ratings, just because the debts were sold onto supposedly 'safe, reputable' banks. The financial crisis showed that having a reputable name like Lehman Brothers mean nothing if your business plan was no good.

Complexity of Financial Assets

• The complex and opaque nature of structured finance assets hid the underlying nature of risky assets. E.g. many banks said they weren't aware of how much risk they were letting themselves in for.
• Many supposedly 'rock solid' banks got involved in buying risky mortgage bundles that they didn't either check or know what exactly were

Failure to Properly Assess Risk

• The ease of passing on risk to other financial bodies creating poor incentives to improve welfare and ensure borrowers could repay.
• Assessment of risk based on past behaviour allowing new practices to be ignored
• Too much emphasis placed on erroneous credit ratings placed by credit agencies who were too close to the companies issuing debt. Many subprime mortgage debts were getting triple A + ratings.
• Failure to assess correctly the liquidity of assets and and the assumption credit markets would always remain fully open.

Short Term Gain - Poor Business Models.

• Too much emphasis was placed on maximising short term returns at expense of sound long term business practices. This is evident in the way many banks borrowed short to lend long. E.g. Northern Rock financed the growth of its risky but once profitable mortgage sector through borrowing on short term money markets. It is no coincidence that new banks (former building societies) like Bradford & Bingley, Halifax, Northern Rock have all suffered from the credit crunch the most. Basically, banks departed from traditional business models and engaged in more extensive lending practices to try and gain market share.
• Growth of Financial speculation. Derivative trading is often misunderstood. But, many banks exposed themselves to precarious positions by effectively betting on the movement of share prices and other assets. Fine in booming markets, but, the activity is largely non productive and exacerbates risk.

Credit Boom

• By focusing on inflation, monetary authorities ignored growing evidence of a credit boom, which led to asset price booms, most notably in housing.
• Monetary Policy Too Lax. Interest rates cut in 2001, in wake of ICT recession. But, interest rates were kept too low for too long. This lax monetary policy, fuelled the credit and housing boom. For instance For instance, John Taylor [1] has calculated that applying his eponymous Taylor Rule in mid-2004 would have pointed to a Federal Funds rate as much as 300 basis points higher.

Related

• Boom and Bust in US Housing Market
• A Humorous look at subprime crisis
• Who is to Blame for Credit Crunch
  

1 John B. Taylor, ‘Housing and Monetary Policy’ in Housing, Housing Finance and Monetary Policy, Federal Reserve Bank of Kansas City, 2008.