Some recent Readers Questions:

• What is difference and similarities between ECB and Bank of England? - Basically, ECB has a narrower target for just focusing on inflation
• Quite a few people have been asking about printing money - In normal times printing money causes inflation. But, with deflation and a falling velocity of circulation it is more complicated and we can print money without causing inflation. Though it is a difficult balance to get it just right. Problem of printing money (Printing money and effect on sterling) (money explained)
  
• Video on Euro and Recession. Would membership of the Euro have avoided Recession? - I can't see how. Would membership of the Euro help recover from a recession - I can't see how, it could make it worse for UK
• History of National debt in Japan. Japan's economy looks really vulnerable at moment. It is being battered by a strong Yen. The size of the national debt and debt interest payments is very large.
• Greek Economy - Greece is another country with huge national debt
• UK National Debt updated - now standing at 47.5% of GDP (40% of GDP excluding bank bailouts)
• Factors that affect house prices
  

The growth and stability pact states members of the Eurozone should not borrow more than 3% of GDP. The argument is that being a member of the Euro means countries need to follow fiscal responsibility otherwise they will be a divergence in bond yields putting stress on the Euro economy.

It is argued governments have political pressure to borrow more, so rules help to keep borrowing under prudent limits.

The problem is that under certain circumstances it may be better for countries to borrow more than 3% of GDP.

In a recession, automatic fiscal stabilisers mean taxes fall and benefits rise. This helps to cushion the impact of a recession by increasing government borrowing

However, for some countries a recession may mean breaking the fiscal rules, therefore to stick to the growth and stability pact may require higher taxes and lower spending. This will reduce consumer spending and economic activity making the recession worse.

This is what governments in UK and US did in 1931 in response to the great depression. It meant that the depression just got deeper and worse.

It is not surprising many countries have ignored the rules and borrowed more.

This does not mean that fiscal responsibility is not a good thing. Governments should seek to maintain fiscal responsibility and reduce budget deficits - especially during boom years. However, in a recession, the last thing you want is to be burdened with rules forcing you to increase taxes and deflate the economy.

In the UK's case if we had been constrained by fiscal and stability rules we would have seen an increase in VAT rather than cut in VAT. This would have led to big fall in economic activity.

Consider the case of Spanish Economy

• They are entering into a recession.
• The housing boom has turned to a painful bust.
• Unemployment already at an EU high of 15% is rising again.
• Construction sector has been hard hit by the credit crisis and the fall in house prices

It is little comfort that Spain's banks avoided the worst excesses of subprime lending fiasco. Compared to Britain and American banks, Spanish banks have been a model of common sense. Yet, they still find themselves facing a recession with few policy options available.

• Monetary Policy - Interest rates are set by the ECB for the whole eurozone area. Cuts depend on inflation prospects in Germany as much as recession on the periphery of the Eurozone.
• Growth and stability pact states member countries can borrow a maximum of 3% of GDP. This means that in theory, Spain will have to respond to recession by fiscal tightening - increasing taxes and cutting spending - something which will make the recession worse. This is why many call it the growth and stupidity pact.
• Devaluation. No scope for devaluation to improve current account deficit or improve competitiveness.

• Should UK Join Euro?

Readers Question: Can you avoid a recession?

If there is a lack of aggregate demand in the economy You can try various policies to boost demand.

• Fiscal policy (higher spending, lower taxes - The principle is that government borrow to offset the rise in private sector spending)
• Monetary policy (lower interest rates)
• Quantitative easing - increasing money supply. This may be necessary if the recession is so severe it creates deflation. Deflation has a powerful negative impact on consumer spending and economic growth
  

If the fall in demand is moderate, these policies may be successful in boosting demand and avoiding a recession. However, if the downturn is severe. If it is caused by:

• falling house prices / assets
• Credit crisis leading to fall in bank lending

Then it is much more difficult to avoid a recession, because these create powerful decreases in economic activity. In this case the government can only minimise the depth and length of the recession. There are also significant time lags in these policies working

Because the recession still occurs, people may reason that these policies have failed. But, the recession may have been even deeper if the policies had not been implemented

• How to avoid recession

• What happens in a recession?
• Can tax cuts avoid a recession?
  

Readers Questions: What are the factors that makes today’s economic crisis? Which of them are the most important in today’s economic crisis?

Some of the most significant factors in causing today's economic crisis:

• A glut of saving from Asia. A glut of savings poured into US and similar countries like UK. This kept US interest rates low and encouraged high levels of consumer spending in US. It encouraged a large current account deficit in the US. It also encouraged an asset bubble, because it was cheap to borrow and this encouraged unsustainable lending.
• US interest rates kept too low for too long around 2003-2005. This encouraged an asset bubble, especially in US. The problem was that inflation was low and people felt this was the most important target. In targetting inflation, people ignored the asset bubble. (see: Mistakes of Alan Greenspan)
  
• Bad Loans. Probably the biggest cause of the current credit crisis. Banks and mortgage companies made a serious of bad loans especially for subprime mortgages. Basically, people were lent mortgages they had no realistic chance of repaying. Mortgage companies and banks were left with a series of bad debts they had to write off. (see: Subprime crisis)
  
• Lack of Capital reserves. In the boom years, banks pursued a reckless dash for growth. This meant lending a high % of deposits. Therefore, when they suffered bad losses. They had no reserves to call upon. This led to a dramatic drop in bank loans which had ripple effects throughout the economy.
• Reselling of Bad Loans. Most of the bad loans originated in the US subprime mortgage market. However, these were rebundled and repackaged into collaterised debt obligations. They were given triple a ratings and bought by banks around the world. Therefore, when mortgage defaults occured in the US, the losses were felt by the whole global banking system because most banks had some exposure to these bad loans.
• Boom and Bust in Housing Markets. Starting in the US, house prices shot up and then fell rapidly. Falling house prices reduce consumer spending and consumer confidence. Also banks losses were increased by falling house prices. Asset bubbles and booms are often associated with prolonged recessions (depressions) (see: Boom and bust in US Housing Market)
  

Who is to Blame?

1. Banks who made irresponsible loans to people who would struggle to repay (especially in America)
2. Banks who were irresponsible in pursuing growth at cost of lower capital reserve ratios. especially banks like Northern Rock, RBS. This meant they are requiring bailouts because they have run out of cash.
3. Regulators who did little to ensure banks were pursuing sustainable lending practicies.
4. Central Banks / Governments who did little to prevent asset bubble and bust.

See: who is to blame for credit crunch?

• Financial crisis explained

A great video with Stephen Colbart and Niall Ferguson talking about his book the Ascent of Money. It's funny but raises some of the basics about what money is and why it is considered money.

• Ascent of Money at Amazon.co.uk
• Ascent of Money at Amazon.com

Hat tip: Forte Finance

Forte Finance included Financial crisis explained in their comprehensive list of 'Best of Credit Crunch'

Recently, the Conservative front bench suggested the spectre of Britain going bankrupt or requiring a bailout like in the 1970s. Although the most recent, bank bailout was very unsatisfactory because the extent of liabilities was left uncertain, bankruptcy seems a remote possibility.

Firstly, public sector debt is 47.5% of GDP. This is forecast to rise to 57.4% by 2012 due to the effects of the recession, bank bailouts and fiscal expansion. In the 1970s national debt rose to over 70% of GDP. After the second world war, national debt was over 125% of GDP (I"m uncertain of exact figure in 1945. It's just amazing that faced with such a huge debt, the government went ahead and created a national health service and comprehensive welfare state!)


source: ons

However, if we ignore the cost of bailing out banks public sector debt is just above 40.5% of GDP. Due to the nature of accounting rules, the effective nationalisation of RBS means we include their liabilities but not the assets such as mortgages and loans. True the recession will cause a rise in repossession rates, but, the majority of loans will be repaid. There is a good chance the cost of the banking bailouts will be at least partly recovered.

But what About the unlimited Liabilities of Guaranteeing Bank loans?

This could potentially expose the government to huge losses. But, the government point out banks are paying a fee for the service and many of the loans will come good. The markets had a less optimistic view leading to a further depreciation in Sterling. But, it is not a complete collapse, more than anything the markets dislike the uncertainty of not knowing the extent of future liabilities.
This scheme does create the potential for large debt, especially if a recession moves into a deep depression. But, it is hopefully not unmanageable.

About 35% of Britain's debt is bought by foreign investors. There is little evidence that this demand is drying up yet. There are bigger problems facing countries like Greece (with 95% debt as a % of GDP)

UK Credit Rating

The credit rating Moody downgraded credit rating of Greece and Spain. It didn't downgrade the UK, because although the outlook was deteriorating in short / medium term this was a response to trying to counter the cyclical recession and so could be seen as a 'calculated risk'

Long Term Pension Liabilities

Another unwelcome issue is the long term pension liabilities which will become an increasing drain from around 2015, as the retired population increases. But, moves to increase retirement age may help.

• UK National Debt
• Ken Clarke dismisses claim Britain facing bankruptcy
• How much debt does UK have? at Guardian
  

After growing by 6% in 2007 and enjoying a prolonged boom since the mid 1990s, Ireland was the first EU economy to enter recession in 2008. The reasons for the Irish recession are similar to the UK.

Reasons for Irish Recession

• Collapse in the Housing Boom. After record levels of house price rises, the Irish housing market turned and now house prices are falling rapidly causing a decline in consumer spending.
• Decline in Construction. Since the mid 1990s, the construction sector has been a backbone of the Irish economy (accounting for 25% of GDP - the highest figure in the EU) With banks unable to lend and house prices falling, construction has declined rapidly causing unemployment and falling spending.
• Banking Sector in turmoil. Like the UK, Ireland has a major problem with the banking sector. Banks have lost money in bad debts and are now struggling to repair their balance sheet. Many have been nationalised or are facing effective nationalisation.
  
• Falling consumer spending.
• Decline Global demand. Irish exports are slowing down exacerbated by a strong Euro and falling growth in US, UK and the Eurozone.
• The Irish economy is closely tied to the US economy. The US gave over 33% of inward investment into Irish manfacturing. The recession in US is likely to cause a knock on effect in Ireland.

The Euro is No Protection against Economic Crisis

The Euro can offer exchange rate stability and strength. But, membership of the Euro also brings drawbacks in a recession. There is no scope for a devaluation to improve competitiveness of exports and encourage growth.
There are also limits on government spending to boost the aggregate demand. (Growth and stability pact)
It is argued that the Euro's stability encouraged many fringe economies like Ireland, Greece and Spain to borrow more than prudent causing rising levels of debt, which credit markets are now reluctant to support.

Forecasts for Irish Economy 2009 2010

The Economist predicts 3 years of negative growth. This is one of the most pessimistic forecast for any economy. It is based on the significance of a declining property market. The economist forecast growth by 2011, but, even this is dependent on stablising a declining property market.

• Overvalued global house prices
  
• Irish economy at Economist
• Myths of Irish economy at Finfacts

Statistics showed a rise in net public sector borrowing to nearly £700bn or 47.5% of GDP (UK National Debt)

The UK budget deficit is the annual borrowing requirement and looking at Treasury projections public borrowing will rise sharply over the next few years.

Government borrowing is predicted to be so high this year because of

• Cyclical factors. In a recession tax revenues fall. People earn less so income tax receipts. People spend less so VAT revenues fall.
• Falling house prices particularly affect stamp duty.
• Income tax receipts have been hard hit by the fact the recession has hit the financial sector hardest. It is high paying city financers who pay a disproportionate amount of income tax.
• As unemployment rises the government is forced to spend more on unemployment benefits.
• Bank bailouts are costing the government more than originally anticipated.

The extent of government borrowing depends on how quickly the economy recovers from recession. In the past treasury forecasts have proved too optimistic and growth has fallen more than anticipated. If the recession is deeper than predicted and if house prices continue to fall, it is likely these forecasts for annual borrowing will be higher.

On top of these cyclical factors, there is also the underlying deterioration of public finances due to demographic factors.

The only crumb of comfort for the government is that at least interest rates are low making the cost of servicing the national debt low.

The Monetarist explanation of the Great Depression focuses on the collapse in the Money Supply which occured in the early 1930s.

Economists like Milton Freidman say the real mistake was allowing banks to go bankrupt causing a decline in the money supply and also loss of confidence in the banking sector. This decline in the money supply caused deflation and a dramatic fall in demand and output.

The current chairman of Federal Reserve Ben Bernanke admitted the Federal Reserve made a huge mistake in the Great Depression, but, it is a mistake they promise not to repeat.

Being true to his word, the Fed and government are doing everything they can with Monetary Policy. Interest rates cut to 0%, bailouts for banks and also increasing the money supply through quantitative easing.

The problem is that even this radical monetary policy seems unable to stem the fall in sales, record rises in unemployment and the huge falls in Output.

This is not just a usual boom and bust cycle it involves the unwinding of a credit and asset bubble.

It is in this scenario of failed Monetary policy, that Keynes advocated expansionary fiscal policy. In other words governments should borrow and spend to offset the fall in private investment and spending.

The problem is that US debt is already high therefore, the Obama team will be nervous about implementing more than a modest fiscal stimulus (the structural budge deficit of the Bush year's will be one legacy of profound regret for all)

Even this moderate fiscal expansion may be insufficient to deal with the extent of the downturn. And then people will criticise the fiscal injection as not working. But, that may miss the point; yes, it may fail to solve the recession, but, the recession would have been even deeper without it.

The Pound has been weak because:

• Recession
• Low Interest rates
• Increasing National Debt (see: Why debt affects Sterling)
• (falling value of sterling)
  

However, there is now another factor weighing down on Sterling - the prospect of quantitative easing (basically quantitative easing involves increasing money supply by Bank of England buying government bonds) It is a bit like a modern form of printing money. The Governor of the Bank of England is proposing quantitative easing as a response to potential deflation and a failure of standard monetary policy (i.e. interest rate cuts not having much affect on demand)

However, the problem with quantitative easing is that increasing the money supply tends to depreciate the value of your currency. This is because it is less attractive to hold sterling if the value of sterling is going to be reduced by increasing money supply and inflation.

At the moment, the Bank haven't committed to quantitative easing - they will probably cut interest rates to 0%.

It is also worth remembering that although the Pound has weakened sharply against the dollar - to a low of £1 = $1.38, the US has already started quantitative easing, has a higher national debt, and their banking sector is just as fragile.

Readers Question: How far can the pound fall before the government has to protect its citizens from the effects of a worthless currency?

The first issue is whether the government can actually do anything meaningful to influence the exchange rate.

The first option is to Buy Pounds on the Foreign Exchange. However, compared to international currency flows, government reserves are only a fraction of the total value. It could use its foreign currency reserves to buy Pound sterling but this would only have a limited impact on raising the value of the Pound. In 1992, when the government spent £21 billion on buying Sterling, investors just saw the government as a source of easy profit. People made like George Soros made a fortune out of the government's attempt to buck the market. (government lost about £3.5 billion during this period)

The second option would be to raise interest rates. The fall in interest rates is a significant factor behind the current fall in the Pound. Higher rates would attract hot money flows and raise the value of sterling. However, the cost of raising rates in the midst of a recession is very high. Even with rate cuts output is falling at the fastest rate since the war. Increasing interest rates could push the economy from a recession into a real depression. Even if interest rates were increased the markets may feel it is unsustainable and so only likely to last for a short time.

The third option would be to introduce exchange controls and try limit the amount of pounds leaving the economy. China uses exchange controls to keep the Yuan undervalued. It means it is difficult to exchange Yuan into other currencies. (my Chinese students have to goto Hong Kong to get British Pounds to study in the UK)

(Fourth option - is to reduce government debt and liabilities. The risk of debt default is a potential cause of Sterling collapsing. Unfortunately the second bank bailout have diminished the prospects of Sterling)

The problem is that government attempts to influence the exchange rate often fail or cause serious side-effects. The lessons of Britain's attempt to stay in the ERM in 1992 are a good example.

Exchange Rates are Not the Problem but the Symptom.

Often a depreciation in the exchange rate is the symptom of other problems.

• A balance of payments crisis e.g. a country cannot finance its current account deficit - like Iceland
• A plunge into recession which causes interest rates to fall and hot money flows to leak out.
• A decline in competitiveness high inflation.

Therefore trying to influence the value of the exchange rate deals with the effect rather than the cause. It's like trying to deal with a leaky pipe by mopping up the water - It would be more effective to mend the leak.

How much is exchange Rate falling?

The other issues is how much the exchange rate is falling, a gradual depreciation like the Dollar since 2001 or the Pound since summer 2008, is different to a collapse in the currency like the Icelandic Krona earlier in the year bought about by a balance of payments crisis.

Is An Exchange Rate Decline the End of the World?

There is an assumption that a falling exchange rate is bad for the economy. It is certainly bad for people importing from Europe, and definitely bad for those living in Europe. But, others benefit. It is good for exporters. In a recession, the government is likely to be glad from the boost to domestic demand that a falling currency brings. In a boom they may worry about the inflationary effects, but not in a recession.

It may be little comfort for those trying to live in Europe on a declining Sterling based income, but the government has to consider all stakeholders in the exchange rate.

However, there does come a point when a slumping pound may start to undermine the credibility of UK economic policy. This is a problem and makes all policy more difficult.

Update: I wrote this piece at the weekend. Since writing it, Sterling's prospects have nosedived after large government underwriting of bank debt. Whatever you think about the merits of this action, it is probably going to weaken sterling in the coming months.

Update 2 Also Sterling has fallen on prospects of quantitative easing. I will post another post later today on this.

I often write articles in advance of publication. I wrote yesterday's piece - Why Bitter Medicine may be necessary before knowing details of the government's latest bailout for the banks. A couple of hours after publication, it was already starting to look a little dated.

The problem is that given developments of yesterday, the 'bitter medicine' of bank bailouts appears even more painful with no guarantee of making the ailing patient (the UK economy) much better.

Outstanding public sector debt for the moment remains at a reasonably respectable 44% of GDP. Compared to our competitors this appears actually quite good. But, the problem is that this headline figure only tells part of the story.

When we take into account potential liabilities from underwriting the banking sector, the figures theoretically threaten the solvency of UK plc.

If the bank bailout works and the economy recovers, then these liabilities and guarantees may never have to be honoured, and in due course, the government will be able to repay some of its debt and breathe a deep sigh of relief.

But, by offering to underwrite so much of the banking sector, the government is in danger of lowering Britain's credit rating. This is actually quite serious. If markets fear there is a chance Britain could default on debt, it will be more difficult to sell bonds, bond yields will be pushed upwards and there could be a flight out of Sterling. This would cause a rapid inflationary fall in sterling - quite different from the gradual depreciation of recent months.

This is why yesterday the Pound fell to another low against the dollar.

This is all still a long way off happening, but, if the crisis continues to worsen who can predict, with any certainty, what will happen?

We face awkward economic choices. There are really serious potential problems of underwriting so much of the banking sector. But, there are also risks in doing nothing. Do we let banks run short of cash and risk and severe contraction in aggregate demand? or do we bailout the banks and threaten the credit worthiness of the UK?

I still hope that this bailout will work. That it will enable lending to resume, shorten the recession and prevent a banking collapse. We shall soon see whether this hope is justified.

Many factors affect exchange rates, the traditional factors we teach in economics are:

• Interest rates - higher UK rates attract hot money flows and demand for sterling rises.
  
• Competitiveness - a higher UK inflation rate than our competitors makes our goods less competitive so demand for sterling falls
• Confidence in Economy and exchange rate. A lot of demand is speculative.
• Economic cycle. A recession tends to weaken the Pound because in a recession interest rates are cut.
• Balance of Payments. A large current account deficit can cause a depreciation, especially if it becomes difficult to finance the current account through capital inflows.

How Government Debt Affects the Exchange Rate

• A rapid increase in national debt means the government have to borrow more from the private sector. If markets have 100% confidence in the UK's ability to repay debt - foreigners will be happy to buy some of our debt (through buying bonds and gilts).
• If markets start to worry borrowing is getting too high / unmanageable, then investors will not be keen to hold UK government bonds. They will invest abroad i.e. many sterling assets will be sold. This will reduce demand for sterling on foreign exchange markets and cause a depreciation.

Basically when investing (especially in turbulent times) it makes sense to invest in the safest countries. If markets start to price in a risk of debt default, it will be more more difficult for that country to attract capital flows.

Although UK public sector debt has increased, the headline rate still looks manegable (44% of GDP). The problem is that the government's decision to underwrite unlimited bank losses, means we have large liabilities and potentially huge debt requirements in the future. (far greater than this 44% of GDP)

It is not certain that these liabilities will be exercised and the government will have to borrow, but, if it did it would lead to a huge increase in the governments borrowing requirement that the markets may be unwilling to finance. This is when sterling would really fall.

• It is worth noting that the UK is not alone in having large public sector debt. Nor is it alone in having a fragile banking sector. But, the bailout for banks in the UK have been one of the biggest as a % of GDP.
• It is also worth noting that although government liabilities will increase, they will also be matched by an increase in assets - in theory triple A safe asset backed loans. Liabilites tend to count towards net debt, but assets don't.
• It is not inconceivable the government could even make a profit as many of these assets already have the possibility of default priced in so the market prices are cheap. However, the fall in gilt prices suggests the markets think a loss is far more likely. It will be interesting to see how markets treat Sterling and gilt yields in the coming week.
  

It was Keynes who noted the Paradox of thrift. In troubled times, people took a seemingly rational step to save more. From a personal perspective this decision to save more in a recession makes sense - savings can help to compensate for loss of your job.

The problem is that if consumers save more, it leads to a decline in consumer demand and output. The rise in savings causes a decline in spending and the recession is made worse.

Keynes theory is that the government should borrow to offset (at least some) of the rise in private sector saving. This government borrowing will not 'crowd out' the private sector it will just mop up some of their excess savings in the private sector. Therefore the economy will recover quicker and as the economy recovers tax receipts will rise to reduce the borrowing.

But wasn't it Borrowing and a lack of saving that got us into this problem in the First place?

Many times, I read comments from people who say something along the lines of - This mess was cause by excess borrowing - so why are we trying to borrow more to get out of the mess? Furthermore, the banks don't deserve help. If anyone deserves help it is long suffering virtuous savers.

In the boom years, private sector borrowing did increase to excess levels. In the summer of 2008, the UK savings rate fell to less than 1%. This is indicative of an unbalanced economy. Many problems would have been avoided if savings had been higher and borrowing lower. The credit bubble has proved very damaging. However, the past is gone and we can't change it. The question is what do we want to happen now?

In the medium to long term, a rise in the savings ratio is desirable. Less reliance on borrowing and consumer led growth would be beneficial for the economy.

The thing is we do want an increase in savings, but not just at the moment; a drastic rise in savings (and hence fall in spending) would be very damaging with the present state of the economy. In a recession, a sharp fall in spending and decline in investment could make a recession very deep. The saving ratio will rise in the recession, but we don't want it to rise too fast too soon.

In other words higher savings would be beneficial, but, we don't want to go from one extreme to the other. If we went from a very low saving ratio to a very high ratio it would be damaging to the economy. The government and MPC are trying to moderate the fall in consumer spending. There is logic behind the policies even if it rather galling that we appear to be helping people who don't 'deserve' it.

Why Should the taxpayer guarantee bank loans. Surely the banks don't deserve more taxpayer guarantees?

The banks probably don't 'deserve' loan guarantees. Their business and financial acumen has shown to be quite poor in the past few years. But, we don't want to see to small firms go out business just because they can't get access to short term lending.

It is more important to do the right thing for the economy rather than taking delight from a collapse in the financial sector which would hurt everyone much more.

In other words low interest rates, loan guarantees and tax cuts may prove the least unpalatable medicine. That is not to say there aren't risks such as moral hazard, subsidising inefficient firms. But, problems have to be put into perspective.

By nature I am an optimist. I like to look for the positive. If you give me a glass with 50% of water, it will definitely be half full. I often feel the media is guilty of exaggerating negative news. They jump on bad headlines and give a misleading impression rather than a more balanced picture. For as long as I can remember you will always hear some people bemoaning about the state of the economy.

Recently a government Minister, Baroness Vadera, got herself into hot water for mentioning some green shoots of recovery in the economy (referring to a bonds issue). I always cringe at the way the media will jump on one phrase trying to make political capital from a sentence taken out of context. But, even a sympathetic assessment would struggle to find any real green shoots of recovery.

No matter how hard we look, it can't be avoided that the economic situation is pretty dire and likely to get worse before it gets better. It is true that not all firms are laying workers off - some may even be taking workers on. But, overall the outlook on the job front is pretty dismal. Declining retail sales will cause more big names to go bankrupt. A sector that employs over 3.5 million people directly - will be a source of many job losses in the coming year.

• The housing market continues to worsen - each month seems to bring a new record low of mortgage approvals. Falling house prices are dampening the economy in a powerful way - see Problem of falling house prices
• Manufacturing output is falling. Even the huge depreciation in the Pound has done seemingly little to boost exports.
• The Banking sector seems to stumble from one crisis to the next. The problems is that if the banking sector is in crisis and unwilling to lend, all business are suffering.

I am quite happy if people to seek out good news amongst the carnage. It is important to keep things in perspective - this is not the great depression. Hopefully this year we will see signs of recovery in some sectors. But, green shoots of recovery? - well let's just hope we will have some justification for saying it later in the year....

• The Problem with falling house prices - Margaret Beckett suggested that first time buyers should try to get on the property ladder soon. There is something in the assertion that house prices could well boom again, but not for quite a while. Falling house prices creates a powerful negative momentum which will continue in 2009
• Why Short term funding is drying up
• Are we in an official recession? - amazingly not yet. Though it is only a matter of time before 2008 Q4 statistics are produced confirming what is self-evident to all
• Reasons for Chinese Current account surplus
• Risks of Deflation - Paul Krugman's blog
• Obama rejects Pigou club - Obama talking about reducing petrol tax in America. Economists want tax on gasoline in US raised to reflect the social cost of driving
• The World Economy declining sharply - at Economist

Enron's code of Ethics. A 64 page booklet last published in 2000. It went bankrupt in 2001, after massive accountancy fraud was uncovered. The few remaining copies of Enron were bought on ebay for up to $200 passing into internet folklore.

The Dow at 36,000. Published in 2000 when the Dow was 11,000. The authors made a claim that the Dow Jones would reach 36,000 'soon'. It is currently languishing at around 8,000 after having the worst year since the Great Depression

Why the Real Estate Boom will not Bust - and how you can profit from it. Published in the US in early 2006. The housing market promptly collapsed and is still falling 3 years later.

Note to self: Be wary of making economic predictions.

• Anyone for oil prices to rise to $250 by 2010?

There is an old saying - 'A recession is when your neighbour loses his job. A depression is when you lose your job.'

The definition of a recession is fairly clear - a period of negative growth. see: Definition of Recession

How To Define a Depression?

• A fall in GDP of 10% or more.
• A fall in GDP for over 3 years.

For other definitions of depression you would might want to mention a fall in GDP combined with a period of deflation and mass unemployment of over 20%. Some economists say the cause is important. - Depressions are caused by unwinding credit bubbles rather than exchange rate devaluations which cause a fall in GDP and inflation

Examples of Depressions.

In the Great Depression, US GDP fell 30% between 1929 and 1933. It also fell 13% between 1937-38. With unemployment over 20% and a long period of deflation. It would meet any criteria of a depression and is inevitably used as a yardstick for measuring other depressions.

The Great Depression was also a global phenomenon. In fact many countries experienced a more severe downturn. E.g. countries like Australia and Canada which rely on raw material exports.

The biggest fall in GDP recorded was for the Soviet Union between 1990 and 1998 when recorded GDP fell 45%. However, this was due to the transition from a Command economy to a Free market economy. Part of it can also be explained by 'creative accounting' in the Communist era. Nevertheless it led to widespread economic hardship for the majority of people.

Finland experienced a drop in GDP of 11% in 1993 as it suffered from the collapse of its main trading partner the Soviet Union.

Emerging Economies have also experienced depression like periods of falls in GDP e.g. Argentina GDP fell by 19% between 1998 and 2002.

Causes of Depression

The cause of Depressions are primarily due to unwinding credit / asset bubbles and a consequent fall in money supply causing a sharp fall in demand and prices. This is different to the usual swings in the business cycle.

Are we Facing A Depression?

It is hoped we will avoid a depression because unlike the 1930s, the government is seeking to prevent a collapse in the banking system and a fall in the money supply. Also rather than trying to balance the budget, governments are pursuing expansionary fiscal policy.

However this recession is different to previous recessions which were caused by a mere tightenting of monetary policy. This recession is caused by an unwinding credit / asset bubble which has the capacity to cause paralysis through deflation. For example, it is worrying that US house prices are now in their 3rd year of decline. Also rather worryingly is the fact that so far the economy appears to be not responding to standard policy measures such as tax cuts and interest rates.

However, before we hit the panic button. It is to be expected these policies will have significant time lags. It may be a severe recession but it's still a long way off being a depression (at the moment anyway)

Related

1. Causes of Great Depression
2. essays on the great depression

• Diagnosis of depression at Economist

Austrian economics is a school of thought which places great emphasis on free markets, private property and absence of government intervention. Important Austrian economists include Carl Menger, Ludwig Van Mises, and Freidrich Hayek. Modern day supporters include congressman Ron Paul.

Main Beliefs of Austrian School of Economics

1. Laissez Faire Economics. Proponents of Austrian school of Economics believe in free markets and avoiding government intervention in markets. They argue government intervention usually creates more problems than it solves.

2. Recessions Caused by Credit Cycles. They argue Central Banks encourage excessive growth of credit by keeping interest rates too low for too long. Some argue the credit bust of 2008 is a good example of Austrian economics theory in action. Ludwig Van Mises also predicted the depression of 1929. They are also critical of government attempts to overcome recessions. They argue governments cause recessions but can not overcome them'

3. Support the Gold Standard. Austrian economists are critical of the use of fiat money which enables governments to devalue exchange rates and destroy savings through creating inflation. The gold standard means money would only be created if it can be converted into gold.

4. Critical of Central Banks. Austrian economists are critical of Central banks and their ability to create inflation by printing money and the fractional reserve system.

5. Rejection of statistical econometric models. Austrian economics emphasises the importance of logical deduction from people's behaviour and avoiding the use of statistics and empirical models. This sets them apart from related schools like Chicago and is one reason why they are not in the mainstream of economics.

6. Civil Liberty Support of free markets and control of money supply essential for promoting civil liberty and social progress.

Criticism of Austrian Economics

1. The belief in the efficiency of markets is countered by many examples of market failure. E.g. growth of subprime mortgages / securitisation leading up to credit crisis of 2008
2. High Tax and high spending regimes do not necessarily impinge on social freedoms. E.g. Many western European economies have high tax and high government spending. But, citizens get a comprehensive welfare state, education and health care. This compares favourably with US, where health care is expensive and piece meal.
3. Controlling Money Supply is much more difficult in practise than theory suggests.
4. Gold Standard can create severe economic problems such as the deflation and high unemployment suffered by UK in the 1920s.
5. Models are too subjective and Vague.
6. Keynesian critique that economies will recover without government intervention. Leaving it to market forces may take a very long time to move economy back to full capacity. Their policy prescriptions for the Great Depression are considered to be 'nihilistic' because they advocated no government intervention. They have also been criticised for shaping their political beliefs into economic policy.

Books on Austrian Economics

• Austrian economics at Amazon.co.uk
• Austrian economics at Amazon.com

External Links

• Austrian School of Economics at Wikipedia
• Criticism of Austrian Economics
• What is Austrian Economics at Mises.org
  

Back in 1999 - 2000 there was a great debate about whether UK should join the Euro. Ever since I started teaching Economics, I have been sceptical of the benefits and worried about the potential costs. (Why UK will never join Euro - written 2 years ago) However, with the collapse of the Icelandic Krona and strength of the Euro amidst great financial turmoil it is worth re-evaluating the case for joining the Euro to see whether UK would really benefit.

Firstly, what are the advantages of joining?

• Strength in Numbers. It is no coincidence the Euro has been strong in a year of great financial turmoil. The Euro seems to be a sea of strength amidst collapsing currencies. Being in the Euro also seems to give greater strength to the Bond market (making it easier to finance national debt) as there is less fear of governments defaulting.
• Greater confidence. The current turmoil shows the importance of confidence. Markets so far have faith in the low inflationary record and stability of the ECB.
• Lower transaction costs for business
• Price transparency - easier to compare costs and prices within Eurozone
  
• Less exchange rate volatility - making it easier for firms to predict exchange rate costs. Especially beneficial for British tourists.

Problems of Euro.

Strength of Euro helps mask problems. Because markets have confidence in Euro markets it has arguably encouraged countries to persist with unsustainable deficits. For example, Italy has national debt of over 105% of GDP (roughly twice UK). Because it has been in the Euro, investors have been willing to buy Italian bonds at a lower interest rate than if Italy was not in the Euro. If Italy were not in the Euro they would have faced greater incentives to reduce their high deficit. The Euro doesn't alter the fact Italian debt looks worryingly high, especially with demographic factors making future forecasts look grim.

Strength of Euro is a mixed Blessing. A country like Germany relies on exports for growth. The strong Euro has helped push Germany into recession, even though they didn't have a housing / credit boom and bust. A falling Pound creates bad headlines and grumbles from expats living in France, but, a falling pound does offer some support to exporters in this recession.

• It is worth remembering the experience of 1992, where it was only when UK left ERM and devalued pound that we were able to emerge from recession.

Common Monetary Policy The fact the ECB sets interest rates for the whole Eurozone is still a problem for UK. If the UK was in the Euro, interest rates would be higher. If the UK really did have a much deeper recession, we would like the flexibility to cut rates much more aggresively than in Euroland.

Poor Growth Record of Eurozone. For all the stability of the Euro, it has failed to stimulate economic growth in the Euroarea. GDP per head has remained at around 70% of the US. For several years, the UK was outpacing the Euro economy. Unemployment in the Eurozone has also remained persistently high

The problem is many people see the weakness of the Pound as a reason to join the Euro. But, this assumes the weakness of the Pound is damaging to the economy. The weak Pound isn't causing problems, it is just symptomatic of the economy's weakness.

As a frequent traveller to Europe, part of me would really quite like to have the Euro. But, from an economic perspective, I fear that joining the Euro would still be an unwelcome constraint on UK monetary policy and exchange rate.

Yes, the Euro experiment has proved many critics wrong and it definitely has some advantages. But, it is important not to get carried away, the eurozone area is really facing some testing times.

• Housing busts in Ireland, Spain.
• High deficits in Italy, Greece and Mediterranean
• Recession in major Euro countries.
• The next few months will be just as testing for Euroland as it will for US and UK.

• Should UK join Euro?

In the current economic situation we have

• Low inflation
• Low Pound
• Very low interest rates
• Declining output / rising unemployment

Winners include:

• People with Tracker Mortgages. Tracker mortgages are tied to base rate so as base rates fall, people experience a significant decline in monthly mortgage payments. People with standard variable mortgages have benefited, though not as much because banks have often not passed the whole rate cut onto consumers.
• People with Large Debts. Low interest rates are making interest payments cheaper. One beneficiary of the low interest rates is the government. Interest on public sector debt has declined. Therefore, even though national debt is increasing sharply, the cost of servicing the debt is not rising ( at moment). In theory people with credit card debts should benefit, but, in practise, banks have not passed rate cuts onto those paying credit card debts. Interest rates are still around 16-17%

• UK exporters. The plummeting pound is creating a real boon for exporting firms. They are experiencing rising profit margins which is helping to insulate them from the recession. Nevertheless the global downturn is so severe, that demand is still stagnant and the UK manufacturing sector is still declining.

Losers from Current Crisis

• The Unemployed. Jobs are being lost across the economy from finance to real estate and retail. The costs of unemployment are very high for those affected and dwarf other issues.
• Savers. Savers are losing out because of the low interest rates. The important issue is the real interest rate. Last year, the official interest rate was lower than the inflation rate giving a negative real interest rate. The only comfort was that banks were offering saving rates higher than the base rate.
• People approaching retirement. People approaching retirement are being affected by the decline in the stock market. Because most pension funds invest in the stock market, the value of pensions has declined meaning people will receive lower pension payments.
• British Expats. People living off savings in Euroland are experiencing both lower interest rates and a decline in the Euro value of their income. People who moved to Spain for low living costs are finding everything is becoming more expensive.
• Housing Market. The UK housing market has a twin problem of falling house prices and a stagnant market. It is bad news for anyone associated with the housing market from estate agents to construction workers.
• Government. The recession is bad news for government finances as tax revenues fall and spending commitments rise. This is exacerbated by the need to bailout large banks resulting from credit crisis.
• Finance Sector / Construction Sector. The recession is affecting all areas, but these areas in particular are suffering a sharp downturn.
  

Evaluation

When making a list of winners and losers, it is important to bear in mind which are more significant. For example, some people may be seeing their mortgage payments fall, and they may be benefiting from lower petrol prices and lower VAT. However, they feel this is all outweighed by the fear of unemployment. Therefore, even though they may be technically better off they don't feel it.

Related

• Does anyone benefit from a recession?

With unemployment rising rapidly, especially in sectors like the car industry, there is great political pressure to do something to 'protect jobs' But, is 'protecting jobs' justified from an economic perspective? - I looked at this issue in the merits of bailing out General Motors.

• Protecting the Right Jobs. Unfortunately, the government is often encouraged to protect politically expedient jobs rather than those which are more cost effective. For example, we often hear that the US car industry is 'too big to fail'. Therefore, the government is put under pressure to subsidise the industry to prevent job losses. However, this industry is probably the most uncompetitive and experiencing the fastest decline. Therefore, protecting jobs in the auto industry is relatively more expensive that protecting jobs in other sectors who only face short term pressures rather than the long term decline.

• Protecting Declining Industries. Protecting jobs in practise often means protecting inefficient firms / industries who are struggling to compete. The problem is that trying to support declining industries is a bit like blowing up a punctured tyre - no matter how much air you pump in - the deflating tyre always needs more air. There comes a point when you think what's the point in trying to blow up this deflating tyres? - lets just get a new tyre.

• Structural Change. If you studied history you would have learnt about the Luddites, - workers who went around smashing machines because they feared it was causing jobs to be lost. In a way they were right - these new machines were causing some jobs to be lost. But, less visible was the new jobs being created to make the machines and also the jobs resulting from better productivity and living standards these machines enabled. Whenever industries decline, new industries take their place. The problem is these new job opportunities may take time and be less visible. - This is particularly a problem in a recession.
  

- In 1945, the UK coal industry employed 450,000 men. Today it employs less than 5,000 nobody suggests we should have protected all those 450,000 jobs.

• Protecting People rather than jobs. Rather than give subsidies to prevent unemployment in declining industries, it would be more effective to target money at enabling a smoother transition from one job to the other. If there is oversupply in the global car market, government subsidies will not solve that (in fact it will just prolong the problem). What the government should do, if anything, is deal with the market failure arising from job losses. For example, the government could provide re-training and education schemes to help the unemployed find new work. Of course, it is easy to say in theory, but, more difficult to implement in practise. Nevertheless, 'protecting jobs' is nearly always an expensive and inefficient way to try and prevent unemployment.

More on Unemployment in UK

Not a day goes by without some big High

The technological ipod age could have serious impact on the High street and change it beyond recognition in the next 2 decades.

It seems not a day goes by without some big retail name closing down - Woolworths, Zappis (former Virgin records), Adams. We can attribute both partly to the recession. But, a recession is often short term catalyst for highlighting long term declining performance. Woolworths lacked a focus - it became a jack of all trades master of none. If you want cheap clothes why not go to a cheap clothes specialist like Matalan? If you want to buy a CD, why not go to a proper music shop?

Of course, people are not even going to proper record shops. The ipod and internet have changed the way people 'buy' music. I often ask my students how they buy music; they usually respond like if I had asked them - "Where do they still buy 7" singles?" My students often say they don't buy music as if it was something perfectly natural and why did people ever buy it? With this kind of attitude to buying music, it is not surprising that music shops, like video rental will soon be on the way out.

Will This Increase Unemployment?

The internet will change the nature of the high street. They will be a rise in unemployment as record shops close down. This unemployment will last longer because of the current recession. But, the rise in unemployment will not be permanent. As jobs are lost in one industry they will be created in others. It is hard to predict the future high street. But, I would expect some shops / services to do well.

• Cafes with wireless access
• Cinemas. The Rental video nearly killed off the cinema in the 1970s and 1980s. But, recent evidence suggests that despite the fact you could download any film from internet, people still like the event of going into town paying £5 and watching a film in a cinema. Yes, we could download it for free and watch it on a flat screen, but, man is a social animal.

The 'digital age' could have a profound impact on the high street and it is difficult to predict how it will look in 2 years time let alone 10 years time.

With public sector debt increasing around the world (list of National Debt by country), I often think - how much can governments get away with borrowing? This is an important question. If the governments try to borrow more than markets will lend them, there will be serious economic problems such as inflation, high interest rates and a decline in credit worthiness of the government.

Record Levels of Government Debt

At times Government Debt has been very high:

• US 117% of GDP in 1945 (gross federal debt (1)
  
• During WWII UK national debt increased from £7.1 billion to £21 billion (over roughly 150% of GDP )
• Japan 195% of GDP currently
• Zimbabwe 218% of GDP 2007 est.
  

Governments can Finance Their Debt in Two Main Ways

1. Selling Bonds to the Private sector - either domestic or foreign
2. Central Bank Finance Shortfall in revenue by increasing the money - printing money is a loose analogy.

Factors Which Influence How Much a Government Can Borrow

• Domestic Savings. If consumers have a high savings ratio, there will be a greater ability for the private sector to buy bonds. Japan had very high levels of public sector debt, but, with high domestic savings, there has been a willingness by the private sector to buy the government debt. Similarly, during the Second World War, the government was able to tap into the high levels of domestic savings.
  
• Relative Interest rates. If government bonds pay a high interest rate, then ceteris paribus, it should be easier for the government to borrow. Sometimes, the government can borrow large amounts, even with low interest rates because government bonds are seen as more attractive than other investments. (e.g. demand for US treasuries is quite high at moment because they are seen as a safe investment, and this is a bigger selling point than the paltry 2% interest rate.
• Confidence and Security. Usually, governments are seen as a safe investment. Many governments have never defaulted on debt payments so people are willing to buy bonds because at least they are safe. However, if investors feel a government is too stretched and could default, then it will be more difficult to borrow. Therefore, some countries like Argentina with bad credit histories would find it more difficult to borrow more.
• Foreign Purchase. A country like the US attracts substantial foreign buyers for its debt (Japan, China, UK). This foreign demand makes it easier for government to borrow. However, if investors feared a country could experience inflation and a rapid devaluation, foreigners would not want to hold securities in that country.
• Inflation. Financing the debt by increasing the money supply is risky because of the inflationary effect. Inflation reduces the real value of the government debt, but, that means people will be less willing to hold government bonds. Inflation will require higher interest rates to attract people to keep bonds. In theory, the government can print money to reduce the real value of debt; but existing savers will lose out. If the government creates inflation, it will be more difficult to attract savings in the future.

Related

• National Debt UK
• National Debt

Back in the early 1990s, as the economy plunged into recession, the then Chancellor of the Exchequer, Norman Lamont said in the House of Commons - 'Unemployment is a price worth paying for lower inflation.' It was a similar sentiment shared by Mrs Thatcher in the 1981 recession. Yes, her policies were causing unemployment, but, she would claim it was an inevitable price for dealing with the inflation she inherited. 365 economists wrote to the Times claiming her policies were flawed, but the Iron Lady was not for turning. Unemployment stayed close to 3 million until 1986.

But, in this recession, as unemployment continues its remorseless rise towards 3 million, there is a general consensus that the unemployment is a heavy price to pay for a credit boom and bust.

A good A Level economics question is - Discuss Policies to reduce Unemployment (15). The answer would be something like this. But, the truth is that in current situation, there isn't really anything the government can do to prevent unemployment rising towards 3 million.

We have cut taxes, increased spending and lowered interest rates. We have even experienced a depreciation in the Pound, all of which in theory should boost demand.
In short there is nothing left. The government would not dare borrow more in 2009, we've just about had our limit of fiscal expansion. Interest rates have fallen sharply and could fall to 0% this year. However, the depth of the downturn means the usual policies just aren't working. At best there will be a long time lag before growth restarts. One thing is for sure, the first sign of growth will be greeted with relief by many.

• Can recessions really be a good thing?

The credit crisis and recession has often proved to be much worse than expected. Just when you think things have reached rock bottom, along comes some more bad news - another retailer going bankrupt, more job losses, - new record low levels of mortgage approvals, recession deeper than previously thought e.t.c.

So the problem with writing a post like this is that it could soon look outdated and rather naive. Nevertheless, given the current state of the economy, how does it compare to previous recessions and the Great Depression?

In the great depression, things were really bad; in fact it is hard to imagine how bad things really were.

• Unemployment reached 20% in the UK and US in some areas it was even higher. To put that into context, it would mean an unemployment rate of 5-6 million today.
• There was widespread destitution with little support for the unemployed.
• It create large migrations of people, as the unemployed went in search of work.
  

The depression lasted not one year, but, a decade. Actually, the economy wasn't contracting all the time, in fact between 1933 and 36, the economy was growing, but efforts to balance the budget pushed the US economy back into recession in 1937 and 1938. However, even when the economy was growing, high unemployment persisted. The recession was so deep, that factories closed permanently. There was a fall in Aggregate supply / productive capacity and not just a fall in aggregate demand.

There was little support for the unemployment. Benefits were very low and begrudgingly given. In the UK, means tested benefits meant someone would come round to see what you were eating. (allegedly if you were still eating meat on Wednesday you were too well off to receive benefits.

By comparison, the current recession doesn't compare. However, the extent of the decline in output, suggests that this recession will be deeper than any since the war. Unemployment is rising rapidly, and it will continue rising even when the economy recovers. It could take many months before unemployment stops rising.

A key issue is the extent of deflation. If deflation sets in (Like in the great depression and Japan in the 1990s) it will invariably exacerbate the recession and lengthen it considerably. If deflation is avoided the recession may hopefully last for just 12 months.

Government finances have deteriorated very sharply. But, in the UK, it has not reached a critical stage yet. I would be more concerned about the US economy. National debt is increasing rapidly and will deteriorate even more this year. Rising national debt and quantitative easing could be a bad mix.
The key issue is whether we see recovery by the end of 2009 - it will certainly be greeted with great relief.

Related

• What went wrong with US economy?
• Economic crisis explained

It has been a remarkable year. Financial and Economic Shocks have precipitated a major global recession. But, the events of 2007/08 mean this will not be an ordinary 'boom and bust downturn, it will necessitate big changes in global economies around the world.

How Economic Policy Will Be Different After the Crisis:

New Targets for Monetary Policy.

Before the credit crunch, the primary objective of monetary policy was low Inflation. The argument was that if inflation was low, economies would avoid boom and bust cycles and therefore we could avoid recessions. In the mid 2000s, there was even talk of an end to 'boom and bust' - the end of the trade cycle. However, this recession has made such predictions look rather hopefully. The New Targets for Monetary Policy will include:

Credit Cycle. This credit crunch could be seen as a boom and bust in credit lending (especially for mortgages). Monetary authorities will need to ensure banks don't get carried away with lending beyond their capacity. Banks will need to be forced to keep a certain ratio between assets and liabilities. One principal reason for the collapse of Northern Rock was that 75% of its loans were not backed by savings. - In other words they were borrowing to lend mortgages.

Housing Markets. When UK house prices were rising 25% a year, the MPC said that house price inflation was not their target. If they had increased interest rates to reduce house price inflation, they would have been criticised for going beyond their remit and reducing growth unnecessarily. The thing is nobody felt that house price inflation was their responsibility. But, the impact of house prices on the economy can not be underestimated - they really do have a big impact, therefore reducing house price volatility will be important.

New Instruments of Monetary Policy.

• Quantitative Easing. If deflation becomes widespread, we will see more Central Banks consider quantitative easing (printing money is a loose explanation for QE) However, we hope this will be just a short term measure. There is always a risk associated with increasing the monetary base (especially with large government borrowing) see: Quantitative easing
• Credit Control. It is not possible for Central banks to control inflation, economic growth, house prices, credit,exchange rates just through using interest rates. Monetary authorities will need to develop tools which limit a credit boom and ensure sustainable lending practises. It is exactly the kind of regulation banks would previously have scoffed at. But, with banks on their knees grovelling for bailouts they are no longer in a position to dictate terms.
• Micro Regulation of Finance and Banking. In addition to regulating growth of credit, governments will need to adopt better regulation for certain banking practises.
• Policies to Reduce Volatility of House prices. The UK has now seen two spectacular boom and busts in the housing market in the past two decades. We cannot rely on interest rates to control house prices, but more needs to be done to regulate borrowing. However, with limited supply (in the UK) this is easier said than done.