A while back a wrote an article about bailing out General Motors. Basically General Motors is a company that has been losing money for many years. The global recession has merely heightened its problems leading to requests for huge bailouts. In that article I outlined the dangers of trying to keep afloat an inefficient firm that has been struggling with over capacity for many years.

But, what about other car firms who are very efficient but just struggling under the sharpest downturn in global demand for cars for many years.

One good example, is the Mini Car factory in Cowley Oxford. It is one mile from where I live and I cycle past the factory every day. In the past 10 years I have proudly seen the factory emerge from being the most inefficient car factory in Europe to one of the most efficient and successful car factories. The new mini has been very successful being exported around the world. Only 12 months ago, the factory was taking on extra staff to cope with the unprecedented demand. The bus companies were complaining that the BMW factory was employing so many it was pushing up wages.

But, just last week, BMW announced many job losses and the prospect of shutting down the factory as demand for new cars shrinks.

Should Government Save Car Industry?

If it is an issue of deserving subsidies, the BMW plant makes a compelling case. Proof that in the UK we can still manufacturer efficiently (even if it is owned and managed by the Germans) Certainly compared to reckless bankers in the city, workers could claim they deserve saving.

Unfortunately deserving subsidies doesn't mean the government should do it. Banks don't deserve subsidy but a banking collapse would have too catastrophic impact on the wider economy.

How can government choose which car firms to bailout. I can make an assumption that BMW Mini is efficient and more deserving of subsidy than GM. But, in practise it would be difficult for government to decide the 'best car firms' to subsidise and save. There is also an issue of if we subsidise car firms does that mean we have to subsidise any firm facing bankruptcy in the recession. What is special about the car industry?

Rather than trying to work out the most efficient firm to subsidise the government would be better off using any money it can afford to increase general demand and allow consumers to decide where to spend it.

Cost. The cost of keeping car firms afloat is potentially very high. With government borrowing already very high they can ill afford further subsidies. Furthermore, no one knows how long the car slump will last, it could be short term, but, if the global recession persists it could be a few years. If this is the case the cost to the government could be prohibitively high.

Over supply. One of the problems is that the global car industry is suffering from over supply. For the governments to subsides an industry that is over stretching itself, would merely delay the problems of restructuring.

• Problems of Car industry

Readers Question: Why have house prices in UK fallen since August 2007.

In the period 1995 to 2007, UK house prices rose very rapidly. In 1995, average house prices were £50,000. By 2007 Q3, 12 years later, average house prices had reached £184,000 (see: Nationwide Historical house prices). That is a 268% increase in prices in 12 years. (Inflation was averaging 2-3% in this period) so the increase in real house prices was very high.

Since 2007. House prices have fallen significantly. Why?

Decrease In Mortgage Lending

This is the biggest reason for the decline in house prices. In the boom years, mortgage companies were very keen to lend. Credit was freely available. Banks lent unorthodox mortgages such as 100% mortgages, interest only, self-certification mortgages, mortgages several times income e.t.c. This helped people get on the property ladder (despite rising prices) and this helped house prices increase further. However, due to credit crunch, in 2007 banks found it difficult to raise enough money on money markets. Interbank lending dried up and so companies started to ration credit. Banks simply lost the ability to lend mortgages. People who used to be able to get a mortgage no longer could. Therefore demand dried up - especially from first time buyers. One of the main stumbling blocks was that banks now required big deposits - at least 10% or 25% to get a competitive mortgage rate.

House Prices Overvalued

The ratio of house prices to incomes had increased to high levels. (from 3.3 in 2003) to 5.1 in 2007 (see: Ratio of House price to incomes) People had been able to buy mortgages in the boom year, because of the wide range of generous mortgages. However, now mortgages were scarce housing became effectively unaffordable. Most first time buyers struggled to get a deposit for 10-25%.

Confidence / Expectations.

When house prices are rising, people are keen to buy. Firms are also keen to lend mortgages because a small deposit soon becomes a big deposit. But, when house prices start to fall, the market sentiment changes. If house prices are going to fall 10 or 20% why not wait and save yourself £30,000? When house prices are rising, people want to get on the ladder before they increase too much. In the early 1990s, house prices fell for 4 years before returning to upward movement. As soon as house prices start to fall, people drop out of the market causing the price decrease to exaggerate.

Recession

The recession and rising unemployment has created additional problems for the housing market. Unemployment means people are likely to default on mortgage payments (even with low interest rates) this creates more houses sold on the market. The fear of unemployment also discourages people from buying. The worry is that if defaults increase too much, banks may lose more money and be even more reluctant to lend mortgages.

What Will Happen Next for House prices?

On the pessimistic side.

• Bank lending still constrained
• Recession will worsen situation for homeowners and banks
• Prices still are above long term trends
• Last housing crash lasted four years

On the optimistic side

• Interest rates very low. Therefore mortgage payments relatively attractive compared to renting
• Falls in house prices have increased affordability
• Signs of hope in mortgage market. Northern Rocks new £15 bn amount of mortgages might make a difference to availability of mortgages.
• Supply constraints still a problem in UK. Many millions are on some kind of housing waiting list. This shortage could push up prices
  

Conclusion

House prices will probably continue to fall in 2009. However, there will come a point when people will return to the housing market. Even this crash won't change British people's like for owning a house rather than renting. And as much as we like to own a house we really hate to build them. The supply of new houses continues to be way below government target leaving potential for future shortages.

Overvalued Housing Markets

• Why Banks are not lending. Why lower interest rates are not encouraging people to spend.
• Outlook for Euro looks testing as the Eurozone faces most serious downturn since inauguration of Euro
• Obama faces difficulty of balancing US budget - Higher taxes and lower spending don't garner support, but, only difficult choices will enable US borrowing to come under control (and assuming the economy actually recovers soon.)
• nationalisation of the banks in America look increasingly likely. As Paul Krugman points out, if the Government bailout banks, do they not deserve something in return? Would the private sector pour money into a company without gaining ownership?
• In the UK, RPI inflation fell to 0.1%. RPI includes mortgage interest payments so has fallen much more sharply than CPI inflation which excludes mortgage interest payments. See: difference between RPI, RPIX and CPI.
• Northern Rock has been told to lend more mortgages. When Northern Rock stopped new mortgages, the UK mortgage industry suffered
  

With house prices falling, share prices plummeting and the world economy facing its sharpest slowdown since the Great Depression it is not without irony that we have seen the comeuppance of Maddoff and Stanford in the space of a few months. Both have been charged with embezzling funds and offering false / illusory investment schemes. These investment schemes promise much on the outside, but underneath reveal an emptiness - a mere illusion of false hopes. - perhaps an appropriate allegory for the wider economy.

Some will suggest that these false investment schemes are just a more blatant form of illusory economics that has spread throughout the financial system in recent years. We have bankers borrowing to be able to lend high risk mortgages, banks running down their deposits, and house prices rising to unsustainable levels.

Yet, whilst it is easy to criticise the bankers and government, they couldn't have done it without customers willing to take out loans, sub-prime mortgages and run up big credit card debts. If there was no shortage of dodgy investment schemes, there were also no shortage of people looking for get rich schemes, even if it meant flipping your own home.
In the nineties and naughties there has been an unprecedented fall in the savings rate in the UK and US. There has been a desire to live on credit and spend beyond our means.

We can argue that banks should have known better, they should have regulated themselves and ensured a long term sustainable business plan. This is very true - some of our top bankers have appeared like naughty children gambling with sums as if they were playing a game of monopoly with their 6 year old niece. But, we can't absolve ourselves of all blame. If we run up large credit card debts and take out mortgages we have no chance of repaying (mostly a problem in US) we can plead financial ignorance, but, ultimately we have to share a responsibility for our financial plight.

We need far better, and tighter regulation of the financial system, but, we also need better financial education of ourselves. People borrow, and spend thousands of pounds every year, without knowing the basics of real interest rates, compound interest rates and the impact of credit ratings. Maybe we should introduce a new topic onto the National curriculum - how to spot a Ponzi investment scheme.

At the same time, there is only so much we should engage in a perpetual blame game. The mistakes of the banks need to be carefully analysed. But, we need to do our part in understanding an increasingly complex financial world.

• In the early days of money, gold coins were used to pay for goods. The money had intrinsic value. Cut a gold coin in half and you had two pieces half its value.
• With a rise in the volume of goods and services produced there was a need for notes and coins.
• The gold standard was a way to fix the value of money by allowing them to be converted into a certain amount of gold. This gave people faith in the new 'paper money'.
• For example, in 1717, United Kingdom fixed £1 to 113 grains (7.32 g) of fine gold.
• Throughout the nineteenth and early twentieth century, other countries also adopted the gold standard. They set their currency at a certain level against gold. Exchange rates were very stable and only moved after an agreed adjustment.
  
• American Express could print travellers cheque and say exactly how much foreign currency it would buy.
  

Advantage of Gold Standard

The advantage of the gold standard is that the amount of gold was relatively stable. It means that governments couldn't print money and create inflation. It also created confidence in the financial system.

Breakdown of Gold Standard

• However, in the First world war, the costs of the war were so great countries abandoned the gold standard so they could print more money and pay for war. This led to inflation which persisted after the war.
• After the first world war, countries returned to the gold standard.
• In the early 1920s. Defeated axis powers like Germany, Hungary and Austria couldn't pay their reparations (denominated in gold). Germany printed money causing the famous hyperinflation.
• However, the UK (under Winston Churchill as Chancellor of Exchequer in 1925) rejoined the gold standard at a rate that was too high. The UK economy had suffered during the first world war and the attempt to maintain the £ at the prewar rate caused many problems. Keynes was very critical of the decision:
  

“In truth, the gold standard is already a barbarous relic.”

-Monetary Reform (1924), p. 172

• A return to the gold standard meant UK exports were too expensive causing falling demand for UK manufacturers. In the 1920s, because of the gold standard the UK experienced deflation and a prolonged period of high unemployment (even before the Great Depression)
• On the other hand the US dollar was undervalued, this contributed to a boom in US economy which led to the credit bubble and stock market crash of 1929.
• In the 1930s, the Great depression caused many to leave the gold standards and allow their exchange rate to devalue. The UK left in 1931
• After the second world war, Britain had depleted its gold reserves in paying for the war, a return to the gold standard was not practical.

Bretton Woods

• However, to guard against the inflationary potential of floating exchange rates and Central Banks with power to print money, the Bretton woods system was set up.
• This was a fixed exchange rate system where countries pegged their currency to the dollar and the US fixed the price of gold at $35.
• Bretton woods broke down in the 1970s.

Some (Austrian economists) argue we should rejoin the gold standard to protect against inflation and the power of Central banks to inflate away debt which benefits governments and those with debts but destroys the income of savers.

Disadvantages of Gold Standard

• However, the gold standard has many drawbacks because of its ability to create deflationary pressures e.g. which harmed the UK economy in the 1920s
• Inflation or deflation could be created by variations in production of gold.
• In recessions, monetary policy becomes ineffective because governments cannot increase money supply.
• Fixed exchange rates can encourage speculative attacks on the currency. (e.g. it was argued US was forced to raise interest rates in Great depression to protect value of currency)

• Exchange rates explained

Readers Question: Why is there a global fall in demand for cars?

The car industry faces many problems at moment. Firstly demand is falling because:

1. Global recession, means workers have lower incomes and therefore avoid buying expensive items.
2. Low confidence due to prospect of rising unemployment encourages people to delay buying new cars. The cars are luxury goods. You can get buy on keeping your old car for longer. In a recession we keep buying groceries, food and drinks (essential items) but luxury items get delayed. This is why haute cuisine restaurants will struggle in recession, but the likes of Burger King can actually do better
3. Credit crunch. Many buy new cars with the help of personal loans or remortgaging house. Credit crunch has made loans less available therefore demand has dried up.
4. Falling prices. With falling prices and prospect of falling prices people are delaying buying cars hoping they will be cheaper in the future.

Fundamental over supply

The problems of the car industry are not just cyclical, but structural. General Motors and Ford were struggling before the recession. There is oversupply in the car industry and the American car firms have been losing out due to a lack of competitiveness.

Recently, the American car industries called for a new bailout of $35 billion. I discussed merits of car bailout here:

Even efficient firms are seeing a fall in demand. 1 mile from where I live in Cowley Oxford, BMW announced job losses at its highly successful Mini Cooper factory.

Usually a fall in inflation is seen as good news. It enables lower interest rates, more competitive exports and more competitive prices for consumers.

The problem is that with interest rates already at 1%, there is little enthusiasm to see lower rates in the economy as many feel it would have limited effect at best.

• There is also the prospect of deflation - a negative inflation rate.
• RPI stands at 0.1% This reflects the large fall in interest rates and mortgage interest payments. The CPI gives a better indication of 'underlying inflation
• See: Difference between CPI, RPI, RPIX inflation
• The government set an inflation target of 2% rather than 0%. They are concerned that very low or negative inflation will lead to sluggish growth.

Why are Falling prices bad for the economy?

If lower prices are caused by improved technology and lower costs of production this is not bad but beneficial. However, if they are resulting from sluggish demand it has various problems

1. If prices are falling people delay purchasing goods, especially expensive ones like cars, tvs. This causes lower growth
2. Real Value of debt increases. Deflation means it is harder to pay off your debts. With many people indebted in the UK, this will reduce their spending and disposable income.
3. This is exacerbated because when people took loans, mortages out they had an expectation of inflation. If this inflation fails to materialise the loan will be much more expensive than they expected.
4. Real Wages become too high. Workers tend to resist nominal wage cuts. If prices are falling, real wages will rise. This could cause real wage unemployment and firms are more likely to lay off workers.
   

Falling prices may benefit those who like to keep their gold coins under their mattresses, but deflation is often seen as an important signal of a real depression rather than just a minor recession.

It is hard to believe the Japanese economy was once held up as a model for being the best performing economy in the world. The truth is the Japanese economy is facing tremendous problems.

After staggering along for the past two decades with sluggish growth and deflation

• Japan has seen a budgeoning national debt upto 195% of GDP and forecast to keep rising. Japan debt
• Japanese Debt keeps rising
  
  
• 
  Debt interest payments are becoming an increasing burden(history of debt)
  
• GDP fell at its fastest rate for 35 years, a fall of 3.5% in the last quarter or an annual decline of 12% (one definition of depression is negative growth of over 10%)
• The government have tried frequent monetary and fiscal stimulus but they don't seem to have worked. Interest rates are 0.1% are can't be cut any further. The deficit is so high, that fiscal stimulus border on the reckless.
• It is an unprecedented level of government debt with no prospect of an imminent fall.
• With an ageing population, demographic changes will worsen debt in future.
• Japan's economy has relied to a large extent on exports and global demand. There is nothing they can do about the collapse in global demand. exports fell a record 13% in the fourth quarter of 2008. They are particularly affected by fall in demand for cars.
  

Readers Question: What effect would a long period of very low or zero interest rates have on savers, borrowers and financial businesses in the US and UK?

I’ve read a bit about what happened in Japan in the 90s, but despite zero interest rates, Japanese saving levels still remained high. Traditionally the US and UK don’t have saving levels as high as Japan. Basically I’m asking if the US and UK economy would behave the same way as Japan’s?


Firstly, it depends on what happens to inflation.

• If inflation is 10% and interest rates 11%. Real interest rates are 1%
• If inflation is 0.5% and interest rates are 1.75%. Real interest rates are 1.25%
• If we have deflation (falling prices) CPI of say - 2% and interest rates are 0%. Real interest rates are + 2%

Out of the three options savers would be better off in the situation of interest rates of 0%. If you try saying that to some savers they may not believe you. But, the impact of 0% interest rates does depend very much on inflation or deflation rate.

Then there is the issue of commercial bank rates. The bank of England may cut rates to 0%, but commercial banks may still offer savers some incentive to save because they need deposits. Where possible, commercial banks will resist the cut to 0% for saving and loans. I imagine that even with base rates of 0%, you could find somewhere to get say 2% on savings.


Who Benefits from 0% interest rates?

Borrowers will find mortgage payments cheaper, especially those on tracker / variable mortgages. Firms with loans will benefit from cheaper repayments. But, it is not all good news as 0% interest rates may occur because of falling asset prices. Homeowners are benefiting from low rates, but, suffering from falling equity. If UK house prices start to rise, I would imagine interest rates would increase again. Also if 0% interest rates occur with deflation. Real interest rates are quite high.

How is Exchange Rate affected by 0% interest rates?

If the UK has 0% interest rates and say Eurozone keep rates at 2%, there will be an outflow of money to Europe and the Pound will continue to depreciate. However, the eurozone economy is also in recession and Euro rates could follow UK rates.

When Japan had 0% interest rates and no one else did. It led to the Yen Carry trade where people borrowed in Japan and saved elsewhere. However, if the UK moves to 0% interest rates I imagine many others will have 0% rates as well.

Saving Rates in Japan.

Since the period of 0% interest rates, the measured Japanese Saving rate actually fell quite significantly. (I was a little surprised on researching this) This wasn't because people went out and spent; it reflected demographic changes and other changes in society. In this period consumer spending in Japan was generally stagnant because of deflationary expectations rather than 0% interest rates.

Conclusion

If interest rates were 0% and inflation stayed at the government's target of 2%, it would definitely be bad for savers and good for borrowers. However, I feel 0% interest rates will be introduced to stave off the threat of deflation. Therefore, the impact of 0% interest rates cannot be separated from deflation, or at least very low inflation.

If 0% interest rates do there job it will create inflation, then the 0% interest rates will be temporary. If they don't do there job and deflation sets in. We could experience a long period of 0% interest rates

• interest rates explained
• 0% interest rates
  

Recent readers questions on my other blog have included:

• Is recession caused by domestic or international factors? - A mixture of the two. If the UK had avoided a credit and housing bubble, if the banks had been better regulated, the recession would have been less steep. However, given state of global economy, I doubt we could have avoided some kind of recession
• Why are banks not lending despite lower interest rates? - basically, recession, falling house prices and poor balance sheets all contribute to reluctance of banks to lend.
• UK's trade deficit narrows. - A little bit of good news amidst the gloom
• More on mistakes of the banks
• How to deal with problem of mortgage arrears - Barack Obama has recently announced a scheme to prevent home repossession in the US
  

Graph of UK interest rates

Interesting to see Libor 3 month interbank lending rate coming down.

• Evidence suggested that the Eurozone has plummeted into a deep recession with Eurozone output expected to fall 3% this year. (link)
• One of the big factors was the deterioration in the German economy. The German economy is suffering from the decline in export demand, especially in manufactures. In the last quarter the German economy fell 2.1%.
• The relative strength of the Euro is also hindering the German and other Eurozone economies.
• Pressure will be put on the ECB to cut interest rates. So far, the ECB have been the most conservative Central Bank in responding to the downturn. Interest rates are at 2%, but, could fall as the recession deepens. But, I wonder whether the ECB will be able to shake off their anti-inflationary conservatism and pursue radical policies?
• This prospect of lower interest rates should keep the Euro weaker.
• This week China reported falling export sales, this will be a big blow to the world's fastest growing economy.
  

Many predict the downturn to his the UK the hardest. This is primarily because:

1. The effect of housing boom and bust was very powerful in the UK
2. UK depend on financial sector to provide a significant aspect of GDP. (only 8% of GDP, but 25% of corporate tax revenue)

However, it appears even countries without Housing boom and busts, are suffering from the weight of falling global demand.

• German Economy in recession

Next week I will be looking at:

• Impact of having 0% interest rate policy
• Prospects for recovery in UK
• The UK Housing Market
• other topics that spring to mind.
  

I have a certain reluctance to agree with the editorials of the Daily Express and Daily Mail. But, I feel that in this case, the public disgust at bonuses for bankers is justified.

The first problem with the culture of bank bonuses is that they have encouraged high risk activity.

• If banks make spectacular profits, bankers will gain from juicy bonuses.
• However, if banks make losses, bankers don't have to pay a forfeit, or even lose previous bonuses.
• Therefore it becomes a one way bet to take risky options that may lead to a big payoff. If you are lucky and your risky approach pays off then you are entitled to high bonuses. If the risky option loses out, you don't personally have to pay. Therefore, there is every incentive to take risky options to maximise the chance of high payouts even at the expense of increasing the bank to risk. And this is exactly what happened.

It is this corporate culture that was behind the aggressive lending of Northern Rock and aggressive expansion policies of RBS and Barclays.

At the very least bonuses should be paid after good performance in the medium term. I have no objection to paying bonuses for good performance. The problem is banks defined good performance as producing spectacular short term gains. The bonuses should have been paid to those who didn't take unnecessary risk and get involved in buying collateralised debt.

By their own reckless action, the banks have created tremendous problems for the economy and the tax payer. The fact is that without the taxpayer, the banks would be facing collapse. Since, the taxpayer has bailed out the banks, it is right the taxpayer the government dictates bonus pay policy, at least in the short term.

The other problem is that banks have a long history of encouraging reckless behaviour amongst traders. It was the prospect of high bonuses that encouraged Nick Leeson to break Barings bank. It is not as if this is the first time banks have been on the verge of collapse.

Interestingly, Nobel Prize winning economist Joseph Stiglitz has suggested just let the banks collapse and then take over them. There would be no bonuses then. - Let banks fail - J.Stiglitz

• Why financial crisis occured
• Bank of England warned 10 years ago about Problems of Bonus culture
  

Readers Question: Which political party do you support?

I don't support any political party. In the past I have voted for a couple of different parties. I have also failed to make it to the ballot box. Where possible I try to ignore political ideology. A good economist would try to weigh evidence and draw conclusions even if they went against his political preferences. Sometimes we try to find the economics to support our political point of view. But, in my opinion, this is the wrong approach.

So in theory, I try to be independent of politics. However, in practise, we all have our preferences, ideologies and prejudices. Readers will probably have picked up I have certain preferences.

• Supporting Keynesian fiscal policy under certain circumstances.
• A preference for Pigovian taxes (taxes to make people pay for externalities) e.g. Road congestion charge, tax on fatty foods.
• Greater income redistribution.
• A qualified support for free trade. Generally I support free trade, though there are certain cases where developing countries would be justified to have tariffs.
• A scepticism on the desirability of the Euro for the UK, Ireland, Spain and Greece. (yet, for countries at the heart of the Eurozone it has probably been beneficial.)
• A somewhat reluctant acceptance that free markets are most efficient for distributing resources. Though there are many markets and occasions where we shouldn't leave things to the free market.
  

However, I hope that if compelling evidence suggests these opinions were no longer valid, I would change my mind. A stubborn reluctance to change your mind in the face of contrary evidence does not make you a good economist.

Also, politics tends to encourage us to see things in black and white.

• Everything the government does is bad.
  
• Everything the opposition proposes is rubbish.
  

The problem with economics is that it is a difficult subject. Often issues are not black and white but depend on various factors.

For example, I would give the government about 30% of the blame for the current recession. I would give them about 6/10 for their response to the crisis. They have made some mistakes, but, if I had been chancellor of the exchequer I would have probably made similar ones.
For the last recession in 1991, I would have given the government 85% of the blame.
But, this doesn't mean I support Labour over the Conservative party.

When reading the blogosphere, you often come across economic evangelists, who have an ideological certainty that what they propose has to come true. I am always sceptical of such certainty. The more I study economics the more complicated I realise it is and how difficult it is to predict what will happen.

A good example, is whether increasing money supply increases inflation. Many what a simplistic answer - print money and you will inevitably get hyperinflation like in Germany in 1923. However, it is more complicated than that. It depends on velocity of circulation, it depends on institutional factors that determine use of cash, it depends on inflationary / deflationary expectations e.t.c,

• Should we blame Bank of England for recession?
• Monetary policy and politics

My students complain I'm a harsh marker. So just for a change I thought I'd mark a journalist writing on economics. For some reason I came across this article at the Kansas City Star and found an interesting piece on the current economic stimulus package.

These are a few criticisms of the article:

"First, a stimulus, even if it works, assumes the underlying economy is healthy and just needs a “jump start.” "

No, the whole point of a fiscal stimulus is to provide an injection into the economy when it is well below full capacity. If the underlying economy was healthy there would be no need for fiscal stimulus. Keynesian fiscal policy was developed in response to the great depression. When output fall significantly below full capacity leading to a fall in private sector spending, the government needs to intervene to move the economy out of recession. Fiscal policy can be used to fine tune the economy, but it is difficult to get it right. However, when you are facing the most serious recession since the 1930s, it is clear the economy is in trouble.

"Second, ANY deficit-financed, i.e. inflation-financed, government package cannot be a stimulus. There is no wealth created when money is simply printed."

It is a myth that government deficits always cause inflation. (Japan's national debt of 190% only caused deflation)

Governments borrow to offset the rise in private sector saving that tends to occur in recession. If a deficit is financed by borrowing from the private sector it doesn't cause inflation. One problem the US faces is that the recession is so severe it is causing deflationary pressure. Deflation would exacerbate and lengthen any downturn.

Now, currently, the US Federal reserve is undertaking quantitative easing to try and offset the risk of deflation. This is not without risk of inflation. But, when the velocity of circulation is falling, as at present, increasing the money supply doesn't necessarily cause inflation. (money supply and inflation)

The aim of Keynesian fiscal policy is not to print money (though increasing money supply may be necessary if there is deflation), The aim is to get unemployed resources back into activity. Rather than allowing people and resources to remain unemployed the government actively employs them and this creates a multiplier effect to boost economic growth.

"Let’s throw out his “tired KEYNESIAN policies of the past” and get back to the traditional economics that turned America into a major world power by the early 1900’s."

It was this traditional economics that created the 1920s asset /credit bubble and consequent Wall Street Crash. It was also traditional economics which advised Hoover (and McDonald in the UK) to increase tax and cut spending in 1930-31 at the height of the Great Depression. This ideological insistence that the market would get us out of the recession which caused a steep decline in output, and unemployment to reach 25%.

For all the faults of the government response, thankfully, we are not repeating the mistakes of the great depression where we allowed banks to fail and tried to balance the governments budget which made the initial fall in demand much worse.

There are legitimate questions about the economic stimulus package?

• How much can the government borrow without causing credit markets to be alarmed at the scale of government borrowing
• Is the Stimulus package enough? given the marked decline in output and consumer spending even the large stimulus may be insufficient.
• - What is best form for economic stimulus. Some studies suggest tax cuts are most effective. Some suggest government spending on public works scheme are best. But, can we find reasonable projects to spend money on.

But, the criticism in this article are weak.

A reader left a comment - Is there anything more we could do to solve the recession?

The answer is not very much.

• Monetary Policy - Interest rates have been cut with unprecedented rapidity from 5% to 1%. The MPC may well cut them from 1% to 0%, but, lower rates will have an increasingly limited impact on boosting growth
• Fiscal Policy - The UK government are forecast to borrow £120bn this financial year. At nearly 9% of GDP, they would be very reluctant to borrow more for fear of worrying credit markets at the speed of the deterioration in government finances.
• Exchange Rate. Being outside the Euro has allowed the pound to depreciate helping to make UK exports more competitive. But, with a global recession, demand for exports has stayed stagnant despite the depreciation.
• Quantitative Easing. If deflation occurs, we will need to try quantitative easing to avoid deflationary pressure.

The problem is that we are suffering a painful correction to past excesses. Whilst it makes sense to minimise the extent of the downturn. There is an element of having to live with the correction at least temporarily. There is no magic wand any government can wave to achieve full employment in a couple of months.

Indeed it ironic that many of these policies are encouraging the opposite of what we want in the long term. In the long term we want to reduce government borrowing, private sector borrowing, encourage higher rates of saving and more responsible bank lending.

The problem is that if this all happened straight away, it would cause a very painful fall in output.

Video on What the Government Could do

Readers Question: You say that the UK government is borrowing rather than printing money. Is it borrowing this money from overseas reserves? If so then how does this affect the exchange rate?

UK government borrowing is financed by borrowing from the private sector. Government debt is financed by selling gilts, securities and bonds. Mostly the UK debt is bought by UK private sector groups. (e.g. pension funds, investment trusts, private investors)
However, a certain % of government securities are bought by foreign investors. I'm not sure of the %, but I remember hearing a figure of 25% of UK government debt is held by foreign investors.

If foreigners are buying UK government debt then it increases demand for sterling. If foreign investors became nervous of holding UK government debt (e.g. because of risk of debt default) then the Pound would fall as foreign investors sold their UK securities

• UK National debt
• How is national debt financed?
• UK Debt statistics
  

When recession approaches, the first casualty is often a feeling of international solidarity, and belief in free trade. A recession tends to create an attitude of 'let's batten down the hatches and look after ourselves.'

One of the great mistakes of the Great depression was a rise in protectionist feeling (e.g. the Smoot Hawley tariff act) which led to a sharp reduction in international trade. This made the global recession worse. Some industries may have benefited temporarily from a reduction in international competition. But, other industries suffered from the retaliatory tariff rises. Consumers paid higher prices and bought even less.

If free trade is beneficial in good economic times does it become damaging in a recession?

The problem is often one of perception.

An industry is struggling because of the global downturn. Unions and industry bosses look for causes and see cheaper imports as one reason. If people stopped buying imports, the domestic industry would survive and jobs protected.

Therefore there becomes a powerful political pressure for import tariffs to protect domestic jobs. When unemployment is rising remorselessly towards 3 million, the threat of more job losses becomes a powerful argument.

The problem is that protectionist policies hurt the wider economy.

1. Firstly consumers are worse off because they pay more for imports leaving lower disposable income and lower consumer spending.
2. Secondly, other industries will suffer when countries retaliate by placing tariffs on our exports.
3. Thirdly, raising tariffs on imports may not not protect the declining domestic industries anyway.

• The costs of allowing cheap imports are easy to see - Domestic unemployment.
• The benefits of free trade are more spread out throughout the economy and people often don't make the connecting link between reducing imports and the future reduction in our domestic exports.

Foreign Workers

In a boom, certain sectors become short of labour, this encourages immigration to fill the gaps. When the economy is at full employment, no one minds that foreigners may be working, especially in non desirable jobs. But, when the economy goes into recession and unemployment rises, the fight for jobs becomes intense and people start to ask why should foreigners take our jobs when domestic people are unemployed?

It's a difficult one.

Related

• Free trade policy and paradox
• Free trade arguments
  

Today, the Bank of England is widely expected to cut interest rates again from 1.5% to 1%.

• However, the impact of the rate cut is likely to be limited.
• Some non-nationalised banks have been reluctant to pass the base rate cut onto consumers. For example, the Yorkshire building society have said they will keep their Standard Variable Rate at 4.5% whatever the Bank of England do.
• Banks and Building societies are keen to stress the necessity of keeping savers. Without saving deposits it is difficult to have sufficient fund to lend new mortgages. They argue cutting interest rates could even be counter-productive as it will make it more difficult to attract savings and lend new mortgages
• For some with tracker mortgages, an interest rate of 1%, can mean in theory their mortgage repayments will be £0. Some took out a tracker mortgage which offered a 1% off base rate. These homeowners will have a real bonanza.
• Other mortgage companies will be thankful they inserted a collar clause which limits the amount of rate cuts that get passed on.
• Interest rates explained
  

Readers Question: Any ideas about oil prices for this year? A fall to well below $40 or is it cheap as is? OPEC says that $60-$80 is required for investment in new production facilities and discovery projects.

Oil has proved a volatile commodity. When it was racing towards $150 a barrel in the summer of 2008, few were predicting a collapse to $40 a couple of months later.

Although, the world economy may experience the first period of negative growth since the second world war, in the medium term you would expect demand for oil to continue to rise. As demand rises this should push prices back up.

For some areas of oil production like Siberia and Alaska the cost of producing oil is said to be close to $60-80 so if oil falls below this, they may shut off production at least temporarily. This restriction of supply would also help push prices of oil back up.

One interesting feature of the oil price rise in early 2008 was whether the price rise was due to speculation or 'peak oil theories' - the idea we were close to running out. The fact the price collapsed suggests it was mainly due to speculative demand. Therefore as the economy recovers we may see a more moderate rise in oil prices.

However, as I mentioned in good investments for 2009, I would be very surprised not to see oil prices rising either in the near future or at least by next year.

A prediction I made about oil prices 12 months ago

I have felt that the Pound's depreciation against the Euro was beginning to look overdone. January saw the Pound recover with the Pound showing a record monthly gain to 0.88 to 1 Euro

It is true that economic fundamentals of the the UK remain weak:

• Deepening recession - sharpest recession in OECD
• Low interest rates and likely to fall further
• Housing and mortgage slump
• Rising government debt
• Banks needing bailing out
  

However, the Eurozone economy has very similar problems and in some situations looks worse. E.g. countries like Greece and Italy have had their government credit ratings reduced. Ireland was warned it may be next.

The recovery of the Pound was also helped by a recovery in mortgage approvals. This is a key element to the economy. If the housing market shows recovery and limits the fall in house prices, we might start to see the real beginnings of an economic recovery.

However, before we get too excited, it is worth bearing in mind.

• Mortgage approvals are still very low. The January improvement was against a backdrop of record lows.
• One months improvement is still tenuous recession. This economic crisis has a tendency to get worse just when you least expect it.
• There is little that can be done to prevent the most serious recession since the war. Against this backdrop, interest rates are still likely to continue falling towards 0%
• The UK face a complex set of factors which make recession deeper in UK some analysts are still suggesting pound could fall to $1.2.(bloomberg) However, George Soros has said he has stopped shorting the Pound (selling)
  
• I am writing this on Monday for publication on Wednesday, if I know my luck for predicting exchange rates, the Pound will have collapsed on Tuesday or something....
  

Related

• Predictions for Pound to Euro

Do you think if the US chooses to print the money it will turn into hyper inflation?

It is complicated because at moment, the velocity of circulation (number of transactions) is falling meaning that increasing money base is not causing inflation. But, they need to be careful, if monetary base keeps rising and then velocity of circulation recovers, the US could see a sharp rise in inflation. (Money Supply and inflation in US)

Or will it cause countries around the world to dump dollars leaving the US with worthless money?

If US experiences inflation, then the dollar will depreciate depending on the extent of the inflation. Markets may start to take fright at US policies of quantitative easing, but, at the moment, US is still seen as a relatively safe haven compared to the financial turmoil in the rest of the world. Whether markets will regret seeing the US as a relative 'safe haven' we shall find out in the future.

Or will printing the money actually stop deflation?

Yes, deflation is the primary concern at the moment. The Fed are quite worried about deflation. If deflation sets in the recession will worsen and it makes normal monetary policy ineffective. Deflation makes it very difficult to recover from recession. Therefore, although there are concerns with quantitative easing, the biggest immediate threat is deflation (e.g. Japan in 1990s and 2000s). The last time US had deflation was in the Great Depression. Deflation can be a harbinger of depression. (see: costs of deflation)

Instead of printing the money, if US chooses to issue more debt, who will buy it and what would it mean if foreign countries buy it up?

Upto now, foreign countries such as Japan, China and UK have been buying US debt e.g. US treasury bills and gilts. It is seen as a relatively safe investment (safer than say private sector savings). It means that approximately 25% of US government debt is held externally by countries like China and Japan. These capital flows helped to finance the US current account deficit. If foreign countries stopped buying US debt then:

• Interest rates on US debt would rise.
• US dollar would depreciate.
• There is even risk of partial debt default or inflation

And if US falls what does that mean to the rest of the world?

The US is the largest importer of manufactured goods. If the US went into a prolonged recession, it would definitely worsen the global recession. Countries like Japan and China would be hard hit, because to some extent they rely on exports to the US. There would also be a negative effect on global confidence. For all its faults the US dollar is still seen as the world's reserve currency. If the dollar collapsed where would people put their money? In gold?

• What is more likely inflation or deflation?
• How falling dollar affects US and global economy
• What went wrong with US economy?

The IMF recently stated that the UK economy would shrink 2.8 per cent this year. (UK to face Recession at FT) They also added that the global economy would shrink for the first time since the Second World War. We face a truly global slowdown, but, why is the UK experiencing the worst recession?

Financial Services

This recession is affecting all sectors from the car industry to retail, but, the finance sector is one of the hardest hit. The finance sector is one of Britain's most important sectors in terms of foreign currency earnings and national output. (The sector also makes a significant contribution to income tax and corporation revenues). With hedge funds and interbank lending both declining the Finances sector is in deep recession and rising unemployment.

Housing Market

The UK is not the only country to have a boom and bust in house prices, but, in the UK, the rise in prices was one of the largest. The fall in UK house prices has been one of the sharpest. Also, the UK has one of the highest rates of homeownership in the world. When house prices fall, it has an almost paralysing effect on the economy. The decline in wealth and confidence is a powerful negative impact on consumer spending, once a mainstay of the UK economy.

Low Savings Rate.

The strong period of economic growth in 2000-2007 was driven by consumer spending. The UK saw a rise in personal borrowing and a dramatic drop in the savings rate. In August, 2008, the savings rates was less than 1% - an historical low; compare this to a savings rate of 10%+ in 1994. People are highly indebted and the recession has been a stark reminder of this. I feel we have gone from an attitude of carefree spending to a new attitude of frugality as we try to improve our savings ratio. There is a sharp demand for higher savings.

Reasons that didn't cause a recession to be hardest in UK

Government borrowing. In 2007, government borrowing was 37% of GDP. This really should have been lower given the long period of economic expansion. But, it was not reckless and not a cause of recession.

Why are Government Policies Not Working?

Many Factors have made the recession very severe. The policies of lower interest rates and fiscal expansion may be limiting the depth of the recession. But, they take time to have an effect. But, the main thing is they are being outweighed by other factors.

• UK unemployment
• Video on causes of recession
  

There is a rather confusing array of statistics for measuring Government debt. For the brave, I have written a lengthy post here: Understanding different debt statistics. The problem is that there are many different statistics which offer similar results.

Annual Government borrowing. is measured through:

• PSNCR (used to be called PSBR),
• Cumulative public sector current account, and
• government deficit.

Total Government Debt is measured through:

• Public sector net Debt
• Public sector net Borrowing (similar to net debt, but with different accounting rules)
• National debt. People often refer to public sector net debt as the National debt. However, the national debt is a statistic that is no longer produced. It used to focus on the gross liabilities of the National Loans Fund (whatever that was).
• Government gross general borrowing (ignores net assets and government corporations) and is used on an EU wide scale.
  

• Then on top of that the issue with public sector debt is the extent to which we include imputed debt like PFI and Bank liabilities from privatised banks
• We have public sector debt with bank capitalisations included and we have public sector debt without banking liabilities.
• We also have the issue of how much liabilities we should include from bank nationalisations and loan guarantees.
  
• Then we have some people who think we should include future pension contributions in public sector liabilities.
  

• Looking through the government statistics pages, I really found it quite confusing. Everywhere I looked they seemed to be using different terminology for government borrowing. I've spent 2-3 hours reading through this.
• When I teach A Level economics my main concern is trying to prevent students get confused between government borrowing and the current account deficit.

Of course, US statistics are different as well.

O well, I'm sure this will make for a nice relaxing Sunday morning read!