Recent posts on the other economics blog include:

Which is best method of inflation to use? - Many have been highlighting the zeroflation of RPI showing 0%. Yet, for many people zero inflation doesn't apply. The price of many items is still rising which is why CPI inflation is 3%. The 0% RPI reflects the fall in interest rates and lower mortgage payments. But, David Blanchflower in a recent speech on - The future of monetary policy was suggesting we could use RPIX as the main method of inflation and give a higher priority to housing costs in targetting inflation

Difference Between Recession and Deflation. A recession usually doesn't caused deflation. Deflation is a sign of a 'great recession or depression.

The effects of weak sterling on the economy

Bond Yields on EU debt. The credit crisis has seen a sharp rise in bond yields on Greece and Italian government debt - reflecting the high levels of government borrowing. Why this poses problems should EU seek to pursue Quantitative easing

Why Euro is harming competitiveness when it's needed most

Increased chance of Euro becoming world's reserve currency (A Mixed blessing for EU)

Zimbabwe's hyperinflation has been ended by switching to the US dollar.

It was only last week that we looked at National debt from a historical perspective. As a % of GDP, national debt has been much worse in the past. But, we still face the largest peace time annual budget deficit. The IMF forecast government borrowing of 11% of GDP, others forecast borrowing of upto £180bn.


It is the sharp deterioration in government finances that have concerned the markets.

Last week, the government faced the embarrassment of a failed gilts auction.

Government debt is financed by selling government bonds (or gilts). The Bank of England used to sell gilts but it is now done by a new body - The UK Debt Management Office (DMO)

The UK Debt Management Office (DMO) attracted just £1.67bn in bids for its sale of £1.75bn of 2049 gilts this morning, its first uncovered auction of conventional gilts since 1995.

The cover of just 0.93 times is one of the lowest on records.

Impact of a Failed Gilts Auction:

1. Will put upward pressure on gilt yields. To attract more people to buy gilts, the government will have to offer a higher interest rate to encourage people to buy. This increases the long term cost government borrowing. Higher rates can also be deflationary and reduce economic growth (Higher interest rates from government borrowing are called financial crowding out)
2. Limits future discretionary fiscal policy. The record rise in government borrowing is primarily because of automatic stabilisers. - In a recession tax receipts automatically fall because people pay less income tax and less corporation tax. The government is also spending more on unemployment benefits. However, as Mervyn King pointed out last week, the state of government finances means that future tax cuts and spending increases may be unsustainable.
3. Impact on Credit Rating. Currently the UK has a triple A credit rating. However, any more failed gilt auctions would likely reduce our credit rating making it more difficult and expensive to finance future borrowing.

The DMO is expected to issue £146.6bn of gilts this year - compared to £58bn last year.

• UK National Debt

Parkinson's law of triviality is the idea that organisation give disproportionate time to insignificant items. An example often used is the discussion of a multi million pound power plant. No one really understands the implications so it gets waved through the committee with little discussion. However, when it comes to the issue of whether to provide a bike shed for workers, there could be an animated discussion about - whether to build it, how to build, what colour e.t.c. The reason is people can relate to bike sheds - everyone can have an opinion on this issue. The billion dollar issue never gets discussed - instead the $2,000 bike shed can take many hours of discussion.

When reading the media you often the feel this law of triviality is widespread.

A good example is bonuses for failed bankers. In the UK, endless column inches have been spent on former RBS boss Fred Godwin's £650,000 pension. In the US, there is a similar outrage over bonuses for AIG who have required large bailouts from the US taxpayer.

I think in this case the public outrage is justified (see: problem with bank bonuses) It is more than just the money, but, the principle that taxpayers end up paying for failed bankers who seem to gain in the bad times, just as much as the good times.

Nevertheless given the serious economic problems of - record rises in unemployment, the worst decline in output since the Great Depression, and world trade falling for first time since second world war - how much time is justified in ministers dealing with an issue worth 0.000001% of GDP ?

You might say they are powerless to solve real problems - in fact they might make things worse. At least dealing with the likes of Godwin they are not doing any harm. But, as an economist you have to be aware of opportunity cost. Deal with issues which have maximum impact first and deal with inconsequential issues last.

On a personal note, I recently bought a £5,000 Toyota Corrola. What impressed me most was not the engine, airbags or fuel efficiency; but, the fact that there was a device for telling you how much washing fluid for your screen wipers was left and two cup holders which actually work and don't spill your drink! I mean it's got to be worth £5,000 if they can think of devices like that!

This post was inspired by reading - trivial pursuit by Greg Mankiw

Readers Question: Which economics Blogs do you Read?

I try not to spend too long reading other blogs. But, given the nature of economics, it is vital you read a variety of sources to keep upto date with the latest trends. Also when reading blogs / newspapers I try to be aware of the author's natural bias.

Paul Krugman - Paul Krugman is one of my favourite economists. He was consistent in criticising the Bush decade. He is unashamedly a Keynesian and one of the economists claiming the recent US stimulus package was too small.
Greg Mankiw. Greg comes across as a middle of the road economist. He often just links to other important economic articles across the economic specturm. He is much more sceptical of fiscal stimulus than Paul Krugman.
Freakonomics. Often the posts have little relation to economics, but some provide stimulating discussion. I don't read that often but good for ideas 'out of the box'.
The Bank of England Publications. The Bank of England provide a range of publications. Some of the speeches provide a detailed analysis of UK Monetary policy. These have been very informative
The Economist - The only magazine I actually buy. Some excellent economics articles, though I have always been sceptical of their political stance since supporting election of Bush and invasion of Iraq. It is a simplification to say the Economist is a supporter of free markets. They have analysed the limitations of free markets.
Stephan Economics - BBC's economic blogger. Don't get chance to read that often
Economics Roundtable - an assortment of economic blogs

In addition to these economic blogs, I read the Independent, Times, Guardian and FT.

Ideally I would read more economics blogs there are certainly many more very good blogs which deserve to be read, but, with the internet there is a danger of information overload. Sometimes, you have to sit back and write what you think rather than being an echo chamber of other blogs.

That is why I like receiving readers questions because it gives ideas for questions I wouldn't have thought of writing about. I also bear in mind my own economic students and think of topics that would help them give a better overall understanding of economics for A level.

UK Money Supply

The first shows the Money supply growth adjusted for velocity of circulation. Basically, in a recession, the velocity of circulation falls (people spend less so money changes hands less frequently) Therefore, the effective money supply is much less that the stock of money supply.
This shows the UK has effectively a negative growth in money supply.


The next graph shows the UK experiencing an inflation rate of 0%. Admittedly it is the RPI measure that is 0%. CPI inflation is still 3%. RPI is much lower because it includes mortgage interest payments which have fallen because of the drop in interest rates.

UK Inflation


Nevertheless what this graph doesn't show is the expected fall in CPI inflation due to the large volume of spare capacity in the economy. Given the spare capacity in the economy, deflation is a real problem at the moment.


Given the scale of quantitative easing and increasing the money supply, inflation could be a problem in 12 months time. Removing the excess money supply when the economy recovers will be no easy feat. But, we will have to deal with that problem when we come to it. The first problem is deflation.

Since the government and monetary authorities realised the full extent of the economic downturn in mid 2008, there have been a wave of policies trying to reverse the economic downturn.

Interest Rates.

After a long period of stable interest rates, in the past few months, the MPC have cut interest rates dramatically. From 5% to 0.5%.

In theory lower interest rates:

• Reduce cost of borrowing encouraging investment and spending
  
• Reduce incentive to save
• Reduce mortgage interest payments and so increase disposable incomes

However, interest rates have had limited impact because:

• Banks reluctance to pass base rate cuts onto consumers
• Banks reluctance / inability to lend because of credit crunch and deteriorating economic prospects
• Recession has made people risk averse and encouraged saving rather than consumer spending
• Inevitable time lags of interest rates

2. Fiscal Policy

The recession has caused a rise in government borrowing - lower tax rates and higher government spending. In addition the government has pursued expansionary fiscal policy - lower VAT, higher spending. The impact on government finances has been dramatic. The level of government borrowing next year is forecast to top £180bn (very roughly 13% of GDP - a post war record)

Despite huge fiscal stimulus, output continues to fall and unemployment rise. This is because of the powerful factors slowing the economy down:

• Falling house prices
• Decline in output/ jobs in the finance sector
• Time lags

3. Bailout for Banks

The UK government have effectively nationalised leading banks like Northern Rock and RBS, to prevent banks going under. (bank nationalisation)

4. Purchasing Toxic Debt.

Especially in America, the government / fed have been buying toxic assets to try and improve the balance sheet of American banks - hoping this will encourage more lending. This formed the basis of the Paulson plan and Obama's team seem to have come up with something similar. This policy has been criticised by many - Krugman - calculated risk

5. Quantitative Easing

The UK has started a policy of increasing the money supply to be able to buy assets - corporate bonds and government bonds. The hope is to avoid deflation, and reduce long term interest rates. Some fear quantitative easing will cause inflation. But, at moment there is a large output gap, it is too early to tell the impact of this policy. Quantitative easing

6. Bailouts for Industries

In the US, the government have offered loans and subsidies to the car industry to prevent job losses. In terms of overall aggregate demand, these bailouts are relatively small.

7. Depreciation in Pound

Not really a policy, but, the depreciation in the pound is something that in theory has helped boost competitiveness of exports and boost domestic demand. If the UK was in the Euro, this is something they couldn't have done. The impact of depreciation has been limited by the slowdown in global trade.

Is there any policy left?

Well there is always the helicopter drop - 'dropping notes from the sky'. This could involve giving people vouchers they have to spend by a certain time frame.

• Economic crisis explained

An interesting question at the moment is how much Debt the government can take on.


Looking at the history of UK national debt, the current levels of government borrowing don't seem anything particularly worrying. At the end of the Second World War, UK national debt topped over 200% of GDP. In the twentieth century, national debt has rarely been below 40% of GDP.

People assume national debt must be a disaster for the long term performance of the economy. But, it is worth remembering that in the 1940s, huge levels of National debt didn't prevent the UK:

• Starting a universal National Health Care Service
• Starting universal welfare benefits
• Providing three decades of strong economic growth

Current Levels of UK Government Borrowing

• UK public sector debt is forecast to rise sharply. Ernst & Young ITEM Club, predicted on Saturday that government borrowing would hit £180bn next year (much higher than the government's own prediction of £115bn)
• Also the borrowing figures are complicated by the financial bailouts. Public sector debt figures are liable to soon rise over 100% of GDP, because statistic rules means we must include the liabilities of nationalised banks. However, these liabilities do not require present government borrowing.
• There are also uncertainties about how much more the government will need to spend on the financial bailout. The government has secured many 'bank assets'. It is unclear whether it will need to pay for these.
• There is also a difference between the 1940s and the 2000s. In the 1940s, private sector borrowing was lower. Individuals were willing to do their patriotic duty and buy government war bonds. I doubt there would be the same patriotic fervour to buy 'bonds to save the greedy banks'. The problem today is not just government borrowing, but private sector debt and financial losses.
• The reaction of the markets, particularly in foreign exchange markets has shown that there is growing uncertainty over the UK's ability to borrow.
• However, the UK still has a triple A rating for government borrowing (though that may be downgraded in the future)
• It is a shame and a mistake the government decided to increase public sector borrowing as a % of GDP in the boom years of 2001 - 2006.

Nevertheless, despite the real potential problems of rising government borrowing, it is not quite the end of the world as some suggest.

• How much can we borrow?
• UK National debt
• List of national debt by country
• Source of Graph IFS - Measuring UK's fiscal stance since 1945
  

Public Sector Debt

Readers Question: Are Recessions inevitable?

After we enter a recession, we inevitably start looking for people to blame. Everyone becomes an expert on what we could have done to avoid the recession. Yet, it wasn't so long ago people (especially Gordon Brown) were talking of a new era which had transcended the boom and bust economic cycle of previous decades. To some extent he was right, we at least didn't have an economic boom this time.

Are recessions inevitable?

First, some examples of recessions

Examples of Recession

• The Great Depression
• UK Recession of 1981
  
• UK Recession of 1991-92
• Why is US Facing Recession - 2008
• Whose Fault is the Recession - 2008
• Can Recessions be Avoided?

These examples of recessions show that there are different reasons for recessions in each case. It is difficult to decide whether they could have been avoided or not.

Defining Recessions

• Definition of A Recession
• Simple Guide To Recessions

Causes of Recessions

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

Dealing With Recessions

• Can US and UK avoid Recession? (Jan 08)
• How To Avoid Recessions
• Can Tax Cuts Avoid A Recession
  
• Problems in Recovering from Recessions

Another issue is how long will recessions be? There is no right answer. In our essay on the Great Depression, it seems many mistakes aggravated the initial downturn.

The Great Depression is often studied in history. There has been a resurgence of interest since fears of our current 'great recession' Some myths have developed around the Great Depression.

1. The Fall in Output Lasted Until WW2.


If we look at data for the US economy, the fall in output lasted 4 years from 1929 to March 1933. There then followed a period of economic expansion where growth increased until 1937 regaining previous output levels. The US then experienced a double dip recession in 1937-38, but soon recovered.

Many economists say the depression lasted 10 years because even in 1937, unemployment was in double digit figures. It was not until 1941 and the US entries into the war that unemployment fell to pre-1929 levels.

2. Hoover was a follower of neo clasical Economics.

Hoover oversaw an increase in national debt from 20% to 40% between 1929 and 1933. 1930 to 1931. The federal government’s share of GNP soared from 16.4 percent to 21.5 percent. This was partly due to the fall in tax revenues due to the economic downturn and some attempts to increase government spending. But, Hoover was no Keynesian he was appauled at the rise in National Debt and sought to raise taxes to reduce debt in the early 1930s.

Hoover also sought to protect wages and implemented the Smoot-Hawley Tariff Act - a measure to reduce international trade.
He is associated with the laissez faire approach because he shared a belief that the depression was a necessary 'penance' for previous excesses. He felt that if his policies were given longer enough they would enable a recovery. But, after 3 devastating years he was never given chance to see whether his approach would lead to recovery.

3. Roosevelt was A Good Keynesian

Because of Roosevelt's New Deal, many assume he was an adherent and follower of John M.Keynes and his policies for expansionary fiscal policy. Schemes such as Public Works Administration (PWA) and Works Progress Administration (WPA) did provide some fiscal boost and provided relief to a significant number of unemployment. But, Roosevelt was always a reluctant adherent of Keynes. In particular he was nervous over the idea of government borrowing to finance fiscal expansion. The effect was that the fiscal expansion was much less than Keynes would have advocated leading to only a moderate, insufficient fiscal boost to the economy. Roosevelt increased the top rate of income tax to 73% and later increased it to 90%.
In 1937, worried about government borrowing, Roosevelt increased taxes and cut spending. Unsurprising, the economy returned to another recession.

Also many of Roosevelt's New Deal policies were of dubious value. For example, the National Industrial Recovery Act (NIRA) was really a license for firms to form cartels and raise prices. Because of this it was declared unconstitutional by the Supreme Court. It was a set back for Roosevelt but had nothing to do with Keynesian demand management. The National Recovery Act was also renowned for having a large amount of rules and regulations which created administrative headaches for firms and workers. The problem is that lazy critics say that because some government intervention created problems such as these rules and regulations then QED all government intervention must make things worse.

4. The Stock Market Crash of 1929 is Synonymous with Great Depression.

Many assume the Great depression was caused by great stock market crash of October 1929. Many may equate the two events as being the same thing. However, stock market crashes don't always cause recessions. For example, 1987 stock crash had no effect on the real economy.

The Wall Street Crash was certainly a precipitating factor. The crash reflected the fact the economy was already slowing down; it also helped to reduce confidence, reduce bank liquidity and push the economy into recession. But, the great depression occured because of many more factors:

• the credit bubble
• deflation
• being in the gold standard
• bank collapses and fall in money supply.
• Inappropriate government responses.

• Causes of Great Depression

These lessons from the Great Depression are very relevant for the current economic situation.

1. Credit Bubbles can be Very Damaging.

In the 1920s, the US economy expanded rapidly on the basis of cheap credit, rising money supply and an exuberance bordering on overconfidence. It led to consumers buying large quantities on credit and a booming stock market. By 1928, the US economy was heavily unbalanced with over inflated asset and share prices. (At least one lesson we didn't learn from)

2. Deflation can Devastate Economic Growth.

From 1929, to 1933, in the US the money supply fell by 35%. Prices fell by 33%. This deflation was caused by bank collapses, restriction in lending and adherence to the gold standard. The effects of deflation have widely been shown to be very damaging to the economy.

• Debt Inflation. Falling prices and wages increase the real value of debt. This makes it harder for people to pay off their debt repayments reducing consumer spending. This rising debt burden was exacerbated by the number of American consumers who had bought expensive items on credit with short repayment periods.
• Real Interest Rates Very High. With falling prices, real interest rates were very high, reducing investment.
• Real Wages become too high. Hoover actually tried to bolster the power of labour to set higher wages. But, with falling prices, firms couldn't afford the labour.

(Through zero interest rates and quantitative easing, UK and US central banks have shown they are taking this threat of deflation very seriously)

3. Depressions should not be Seen as a form of Penitence.

In the Great Depression there was a widespread feeling that somehow the depression was a necessary penance for the excesses of the 1920s. In the early stages of the great depression, Treasury Secretary Andrew Mellon, who advised President Hoover told him to:

“Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.... It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people” (Hoover, 1952).

To some extent an unsustainable boom is going to cause a painful period of correction. But, this doesn't mean that the depth of the depression was inevitable. This attitude encouraged a hands off approach to the depression. H.Hoover in his memoires claimed that if only Roosevelt had continued his policies the depression would have been resolved. But, Hoover had 3 years of failed policies which had seen industrial output fall by 33%. It is hard to see how he could have done a worse job.

4. Don't Let Banks Fail.

The Wall Street Crash precipitated many problems, but in 1930, there was no certainty the economic downturn had to develop into a full blow depression. One of the most damaging events was the widespread failure of medium sized American banks - with the Federal Reserve unable or unwilling to act as lender of last resort. The widespread bank failure caused a decline in the money supply and loss of confidence in banking sector - investment fell drastically.

5. Avoid Protectionism and 'Beggar Thy My Neighbour'

The infamous Smoot-Hawley Tariff tariffs of 1930 were designed to protect American jobs by raising tariffs on imports. The consequence is that it led to a global rise in tariffs, reducing trade and exacerbating the global recession. Trade slumped apart from areas of trade preference like within the British Empire. (there are powerful protectionist impulses which will take political courage to avoid)

6. Don't Balance the Budget in a Depression.

The neo-classical response to the depression was to attempt to balance the budget. In the 1931 UK budget, the Labour party was split as Ramsey McDonald followed treasury advice to increase taxes and cut unemployment benefits. This contributed to a further fall in aggregate demand, lower growth and ironically required higher borrowing. In 1932, Hoover increased the top rate of income tax from 24% to 63% in an effort to pay for his modest spending commitments. (thankfully the Republicans lost the US elections. Republican leaders have been calling for a balanced budget). More worryingly the 50 US states have been forced to cut spending to meet legal requirements for state budgets.

7. Fiscal Policy does Help.

Between 1929 and 1931, Japanese GDP fell by 8%. The Japanese Finance Minister Takahashi Korekiyo oversaw a genuine period of expansionary fiscal policy financed by government borrowing. This led to a remarkable turnaround in the Japanese economy; it became one of the first economies to experience lasting recovery.

People often point to the Roosevelt's New Deal as evidence of failed Fiscal Policy. But, the problem with Roosevelt is that he was actually reluctant to finance the New Deal by government borrowing. He wanted to raise taxes to finance it. In 1937, the US made an attempt to balance the budget, this harmed the recovery and was one factor in creating a recession within the depression (37-38).

8. Government Borrowing is not the End of the World.

People assume government borrowing is very damaging. But, in a depression, government borrowing helps to offset the rise in private sector spending. The US was reluctant to borrow until the start of the second world war, when national debt rose to 125% of GDP. It was only then unemployment fell to pre 1929 levels.

9. The Gold Standard was Very Damaging

The Gold standards forced countries to peg their exchange rate at a certain level. In the UK this cause deflationary pressure as the UK lost gold reserves and rejoined at a rate too high. Often countries who left the gold standard were able to recover. E.g. UK recovered after leaving in 1931, the US recovery was delayed until 1933 after leaving. The Netherlands experienced one of the longest economic depressions until it finally left the gold standard in 1936. It was a similar situation for France and Poland

10. Government Intervention doesn't mean micro management of industries.

The New deal was heavy on regulations for industry. The power of labour was increased (e.g. National labour Relations Act1935 - also known as Wagner Act) This led to an rise in strikes and poor industrial relations. Governments set prices for many industries. People were even jailed for selling suits at the wrong price. Keynes didn't advocate this kind of government intervention. He argued the government's main job was to boost demand by government borrowing. This doesn't require a command economy with many fiddly regulations.


11. The Human Cost of Great Depression

After finding the photos for the great depression. I was struck at one obvious lesson from the Great Depression - the human cost. Just read Road to Wigan Pier by George Orwell or J.Steinbeck's classics of this period

Tomorrow - Myths of Great Depression

Further Reading

• Causes of Great Depression
• Essays on Great Depression

Photographs from the Franklin D. Roosevelt Library, courtesy of the National Archives and Records Administration.

Readers Question: I've recently started doing a piece of research on what the first signs of economic recovery could be (what to look out for in other words), following the current slump. Unfortunately (and perhaps predictably) there doesn't appear to be much commentary on this subject. I think a lot of "experts" are reluctant to stick their necks out at the moment. And after the fuss surrounding Baroness Vadera's "green shoots" comment, that isn't surprising. However I wondered if, from a strict economic viewpoint, there might be some predictable indicators that have in the past suggested the worse was over, and the recovery was beginning.

• Inflation rising (sign of stimulus packages working?) perhaps?
• Or maybe house prices stabilising?

Many commentators failed to predict the recession and then failed to predict the depth of the recession. There is a sense that this recession keeps being worse than feared - so as you mention there is a reluctance to start predicting a recovery. But, given current data there is such a negative momentum in the economy that, at best, it will take time to materialise.

The most important data will be seeing positive economic growth. Everyone will breath a sigh of relief to see and end to the plunging output data.

Another key factor will be the banking sector. When bank lending returns to a sense of normal conditions, it will represent a big step in the right direction. Ben Bernacke has recently suggested there are positive signs in this direction. E.g. with citigroup and Merryl Lynch both reporting they were returning to profitability. This is a sign they may start to lend more - without requiring government spending. He suggests because of this development "We'll see the recession coming to an end probably this year," [Guardian link] However, he also warns about the lack of political will to effectively deal with banking problems.

More difficult will be stability in the housing Market. Falling House prices depress consumer spending, consumer wealth and consumer confidence. Any recovery during a period of falling house prices will be tentative at best. This is especially true in the UK where housing makes up a large % of consumer wealth. A sustained period of rising house prices would be great for the economy. However, that may take much longer to occur. In the last housing crash house prices fell for about 4 years. We will hopefully have an economic recovery before waiting for housing market to recover.

False Dawns.

There is also a danger that at the first signs of recovery, the brakes may be slammed on again. Previous growth was based on rising house prices, low savings, high debt. These conditions will not return. There is every danger that any recovery may only be fleeting and we could enter into a double dip recession.

For example, many are concerned that the economic stimulus packages are causing an unwarranted rise in National Debt. Therefore at first chance of recovery governments may put up taxes and cut spending. This could plunge economy into recession again. (e.g. like Roosevelt's deficit reduction budget in 1937, stopped the recovery from the Great Depression. (see article: Life Without Bubbles by Paul Krugman)

Lagging Data

Even if we see a return to positive growth, we are likely to experience a long period of high unemployment. Therefore, although the statistics may show a recovery, the reality is that many may feel we are still in recession. I would imagine unemployment will rise to 3 million in the UK. After the 1981 recession it took several years for this figure to fall.

Inflation.

Deflation or very low inflation is definitely a symptom of economic recession. A more positive inflation is a guide the economy may be recovering. But, it is a limited guide to economic recovery.

Some Commentators feel the Euro is looking overvalued. The Euro is experiencing similar economic downturn to US and UK, but, so far have been reluctant to pursue same reflationary strategies. As the Eurozone interest rates fall towards 0%, the Euro could be subject to the same selling which affected the Pound as interest rates fell. It is debatable whether the ECB would ever be able to bring themselves to implement Quantitative easing.

Bond Prices and Bond Yields. One aspect of quantitative easing was the attempt to reduce bond yields through the Bank of England buying securities. This explains the inverse relationship between bond prices and bond yields

Economic Costs and Benefits of London Olympics. As I evaluated the economic costs and benefits of the London Olympics, I found myself being swayed by non economic factors. Yes, £1billion is alot, but at least it makes a change from losing billions on dodgy banking deals.

Ricardian Equivalence In looking at the impact of government borrowing. Ricardian equivalence claims it doesn't help increase aggregate demand because tax cuts / spending increases financed by borrowing will just encourage people to save because people anticipate future tax rises to pay back debt. However, this theory is of dubious value.

Capitalism beyond the Crisis by A. Sen at New York Times Books. A good look at the current malaise and the need for a wider perspective than just theories of Keynes.

Jon Stewart from Daily Show attacks TV finance Guru's (Video on youtube here)

Through buying assets the Bank of England is increasing the money supply. If we increase the money supply by £100bn what happens?

1. Depends on Money Multiplier

Typically, banks keep a certain reserve in the form of cash.

For example, if they have deposits of £100bn. They may decide to keep 2% or £2bn in the form of cash deposits in the bank. They will lend out £98bn in the form of loans to customers (mortgages, personal loans e.t.c). This enables the bank to make more profit. Because they earn interest on the money that is deposited.

Therefore, if you increase the money supply by £10bn. They may decide to keep £0.2bn of this in cash and lend an extra £9.8bn. This leads to further bank deposits and further bank lending.

Therefore, an initial increase in the money supply can lead to a much bigger increase in the money supply. This is known as the money multiplier. If banks have a deposit ratio of 2%, it means that the final increase in money supply will by 50 * the initial increase in bank lending. If the reserve ratio was 20%, the money multiplier would be 5.

This means that quantitative easing could have a significant impact on increasing money supply in the economy. However, this assumes normal lending conditions.

Since the credit crisis, banks have been trying to build up their cash reserves. Therefore, the problem is that this increase in the money supply may simply be hoarded by commercial banks. Rather than lend it they may just use it to improve their financial position and recover past losses.

It is probable that the Banks will lend some of the money supply increase, but the money multiplier will be very low. One important issue is that we simply don't know how much the policy of money creation will increase the money supply.

Furthermore, money supply figures are notoriously unreliable. Money supply figures can be distorted by financial changes making it difficult to know measure what is happening.

2. Quantitative Easing and Bond Yields

Quantitative easing will impact the interest rate (yield) on government bonds and commercial bonds. The Bank of England will buy securities, therefore their price rises and the interest rate declines. (relationship between bond prices and interest rates)

This lower interest rate may provide a monetary stimulus. As it becomes cheaper for firms to borrow through issuing commercial bonds. This impact may be bigger than the effect of increasing bank cash deposits.

Quantitative Easing and Value of Pound

Quantitative easing increases the risk of inflation, which makes the Pound Sterling less attractive.

Quantitative easing reduces interest rates on UK securities making it less attractive to hold UK securities and bonds. This will reduce demand for holding pounds. Already there has been a widespread selling of UK assets, reducing the Pound.

• Effect of increasing money supply
• Increasing money supply
  

Just a short video where I talk about some of the points I've written about Quantitative easing.

Since the Bank of England's recent announcement about increasing the money supply, there has been much interest in the impact of Quantitative Easing - increasing the money supply by the Bank of England effectively creating money.

Many have linked to a post where I explain how printing money can lead to hyperinflation.

However, this is only half the story. In normal times, printing money faster than growth of Real Output does cause inflation (and indeed could cause hyperinflation). But, these are not normal times.

This recession is very deep, therefore, people are holding onto their money and not spending, meaning increasing the monetary base may be necessary simply to avoid deflation.

In more economic terms, the velocity of circulation is falling; this means in the short term at least, an increase in the money supply does not cause inflation. For more details see: Link between money supply and inflation. This is why the US has experienced very low inflation, despite a dramatic increase in the money supply.

• This is a post from December 2008 about US money supply growth and lack of inflation

• See also: Effect of Money supply on Economy

The problem may occur when velocity of circulation starts to rise as the economy recovers. If there is difficulty in removing excess liquidity we may well get inflation. But, I feel we have to deal with problems in order of priority.

The most pressing and dangerous problem is threat of deflation and the plunge in real output. This is first thing we have to deal with. The prospect of future inflation should not be ignored, but, we can't give priority to inflationary problems in the midst of a depression, with falling output and rising spare capacity.

- To avoid quantitive easing because we might get inflation in one years time, is like not putting a jumper on at night because next morning it will become hot. The point is you put on the jumper because it is cold, but when it gets hot you take it off again (well, that's my attempt at an analogy anyway...)

A further complication is the extent to which an increase in the money supply actually increases the money supply. (Basically, it depends on banks willingness to lend and any money multiplier effect). I will try look at this tomorrow.

The IMF is poised to predict negative growth for the global economy. This is the first period of declining global output since the 1930s. This period of unprecedented economic decline is being referred to as the 'Great Recession'.

In the UK, the recession continues to deepen. Manufacturing output fell by 6.4% in three months to January - giving an annual decline of 12%.

GDP is likely to fall by 4% in 2009. The biggest fall since 1931. (link at Independent)

In a previous post, I looked at some of the causes of the global imbalances in current accounts and domestic saving rates.

Problems of Global Imbalances

China / Asian countries have built up large accumulation of US assets. It means they take a close interest in the strength / prospects of the dollar. If the dollar weakened it could lead to a capital flight from US, further undermining the dollar. On the other hand, you could argue since foreign investors hold so many US assets, they don't want to see the dollar drop sharply.

Cost of debt repayments could rise. At the moment, the US government can finance its national debt at low interest rates. However, if demand for holding dollars dried up, it would find the cost of servicing national debt would rise.
Encouraged low quality loans. The global savings glut artificially reduced interest rates encouraging high levels of borrowing and low saving. It was one factor behind the development of low quality loans such as sub-prime mortgages. It was argued that because there was so much demand for US securities, there were willing buyers for these toxic mortgage bundles which later caused so many problems.

The UK suffered from being the world's reserve currency upto the start of the first world war. After the first world war they rejoined the gold standard but suffered deflation as they struggled to meet the old exchange rate. There was much concern whether UK could meet its old exchange rate requirements.

A recent IMF report argued that the global imbalances were not the primary cause of the recent financial crisis. The IMF argued it was regulatory failure which caused this crisis. The global imbalances only perhaps increased its magnitude. Of course, not everyone agrees with the IMF. The Economist points out that it was the IMF who arguably encouraged global imbalances through their intervention in the South East Asian crisis in 1977 so it is not surprising they blame something else. IMF blame regulatory failure not global imbalances at Economist

Some argue that the global imbalances were an important contributory factor.

Improving Global Imbalances

One benefit of the financial crisis may be to start shifting these global imbalances.

• Already the US current account deficit has fallen as consumers seek to increase their saving rates and reduce their dependence on debt (often dubious mortgage backed debt)
• Other countries such as China, Japan and Germany which relied on export have been hit very hard by the fall in US led demand. They are realising that relying on exports to be the mainstay of growth is just as unbalanced as relying on consumer led borrowing.
• China, Japan and Germany will be forced to look at ways to boost domestic demand to offset the fall in external demand. As I have said previously, it is countries like Germany and China who can benefit most from expansionary Keynesian policies because of the high levels of consumer spending.
• Also, it is likely that the Dollar will have a declining share of the world's global reserves. This would be a good thing as it would place less stress / focus on the US economy. But, on the other hand it could mean in the medium / long term the US is faced with higher interest rates and therefore higher costs of servicing debt. It will mean lower growth, at least, in short term, but, if it helps contribute to a more stable global economy it may be worth it in the long run.
  

• Global imbalances
• What Caused economic crisis?
• Global imbalances and Tiffin dilemna at Reuters

In looking at the causes of the financial crisis, we have often focused on regulatory failure in the mortgage and finance industry. However, as well as regulatory failure there was a large global imbalance between East (mainly China and rest of Asia) and West (mainly US and UK). Many have felt this global imbalance caused, or at least exacerbated the current financial crisis.

What are the Global Imbalances?

1. US ran a large and persistent current account deficit (imports higher than exports) of upto 6.5% of GDP in 2006

Diagram of Current Account Surplus / Deficit in US and rest of world
2. China ran a large current account surplus, accumulated foreign reserves, kept Yuan undervalued and relied on export growth.


3. Savings Glut in Asia. Low savings and high borrowing in US

The high level of savings in Asia was one factor behind the very low savings rate in the US.

Why Global Imbalances?

1. US Dollar world's Reserve currency. Because the US dollar is the world's reserve currency. There has been a large demand for US securities like Treasury bills. These capital flows have effectively financed the US current account and explains why the US has been able to run a larger current account deficit than most other countries.

2. Low Long Term Interest Rates. The high demand for US securities such as US Treasuries and mortgage backed securities helped keep US interest rates low.

For example, the real yield on ten-year inflation-indexed U.S. Treasury securities averaged about 4 percent in 1999 but less than 2 percent in 2004. The real U.S. interest rate (interest rate - inflation), showed a similar pattern, falling from about 3.5 percent in 1996 to about 1.5 percent in 2004 (source: Fed Reserve)

It made borrowing for the US cheaper. There was great demand for savings in the US. This encouraged a US banks to offer increasingly sophisticated forms of investment. It explains why there was so much high demand for US mortgage securities even though the risk was very high.

3. Undervalued Yuan. China has tried to keep the Yuan undervalued to boost its exports. This undervaluation of the Yuan has made Chinese exports cheaper and boosted the Chinese Trade surplus.

• The US have blamed China for the imbalances pointing to the undervaluation of the Yuan. This has been at times a political football, with US politicians deriding the 'protectionist' exchange rate policies of China.
• China have defended themselves saying the global imbalances were caused by the US decision to pursue low interest rates and lax standards in lending criteria. They argue it is their right to pursue their own exchange rate policy. Before, China, the US used to blame Germany and Japan.
  

4. Emerging market economies experienced sharp rise in current account surplus.

• e.g. Oil producing countries benefitted from rising oil revenues due to higher oil prices.
• Asian countries reduced investment and increased savings after South East Asian crisis of 1997

The aggregate current account position of developing countries swung from a deficit of about $80 billion in 1996 to a surplus of roughly $300 billion in 2004, a net move toward surplus of $380 billion.

Problems of Global Imbalances.

Basically, the problem is that the global saving glut made it easier for Americans to borrow and this encouraged an asset bubble (the current bubble could be in US Treasuries). I will look in more detail at this tomorrow.

Looking in my favourite economics textbook, (J.Sloman) there is no mention of quantitative easing. There are lots of policies for reducing inflation. But, in the post war period, when it comes to fighting deflation and depression there is very little experience. Interestingly, the Bank of England has been in close negotiation with the Bank of Japan and the Federal Reserve - perhaps to gain advice on how to implement quantitative easing.

The decision to inject £75bn into the economy (could be upto £150bn or 10% of economy) is a radical step for the Bank of England and the economy. The decision to pursue quantitative easing has been taken because of:

• The extent of the economic downturn
• The fact lower interest rates have not helped the economy recover
• The fact interest rates cannot effectively be cut further (0.5% today)
• The fact inflation is predicted to fall below target of 2% risking prospect of deflation.
  

What is Quantitative Easing?

• The Central bank undertakes to buy various assets - commercial and government bonds from banks. To buy these bonds the Central Bank issues Central Bank reserves. This is effectively creating money through electronic means
  
• Banks gain an increase in liquidity because they sell assets for cash. This increase in banks balance sheets should hopefully encourage them to lend more.
• By buying assets and government bonds. The price of bonds rises causing interest rates on bonds to fall. These lower rates should help boost spending
• Bank of England £75bn Asset purchase scheme at B of E website
  

Possible Problems of Quantitative Easing

• Inflation. When economy recovers it might be difficult to take out the excess money supply causing uncontrollable inflation.
• Investors could lose confidence in economy due to risk of inflation
• Danger of 'bond bubble'. Bonds and gilts will rise in price encouraging investors to buy and interest rates to fall. This could cause a bubble in the price of gilts which could collapse at a later stage causing long term interest rates to rise at an early stage in the business cycle.
• Could cause lower value of Pound - Pound slumps on QE fears
  

• Problem of printing money
• Printing money and inflation
  

A student from Malaysia, wished to interview me for a school project. These are his questions and my answers.

What are your views on the economical downturn?

It's the most serious economic crisis since the Great Depression. The fall in output is very steep. But, also there are a lot of unknowns. - How much bank losses will there be? Will bank lending be able to return to normal? Are there more hidden bad debts? How much debt can the government take on without losing confidence of markets? Will conventional fiscal and monetary policy be sufficient to boost growth?

To a large extent we are in uncharted territory. It is different to previous boom and bust recessions and has features of a depression rather than just recession.

What do you think about the current rescue plan?

The Governments need to do two things

1. Prevent major banks going bankrupt. Effectively this requires nationalisation. There is a hesitancy to do this. But, just buying junk assets is inadequate. US has a reluctance to use nationalisation. But, I think there's no other way.
   
2. Prevent deflation and try to counter the big fall in private spending and investment. Therefore expansionary fiscal policy (like US stimulus plan) and lower interest rates are needed. However, this appears to be insufficient, given magnitude of downturn. Therefore, quantitative easing will be needed to avoid deflationary pressure. I feel if government allow deflation to set in, it would be very serious problem.

Generally, governments and monetary authorities are trying to do the right thing by increasing demand.
But, we also have to be careful short term measures to deal with crisis don't create long term problems. But, this is too complicated to go into in this post.

How long do you think it will last?

Difficult to say. Maybe 9-12 months before positive growth returns. But, even that may not signal end of crisis. It's not just the economy but the wider financial situation that is in difficulty, and the problems won't just vanish.

Why does it affect the world?

• The banking system is interconnected. Shortage of credit in one country is soon a global phenomena. Many banks had some direct or indirect exposure to American subprime debt. So when a few Florida mortgage companies lost money, banks around the world were affected.
• The economy is globally interconnected. E.g. countries like Japan and Germany rely on exports for a significant % of GDP. Therefore they have suffered from downturn even though they didn't experience the same credit bubble as in UK / US. The fall in Japanese exports show how badly affected the economy is.
• See also: Causes of financial / economic crisis
  

What caused the collapse of a substantial housing bubble?

The US housing bubble was based on unconventional mortgages which relied on house prices rising, low deposits and high income multiples. When house prices stopped rising, these mortgages were withdrawn and so demand fell. Banks became reluctant to lend because

• they had lost money
• house prices were falling

Also, many mortgages were missold. They were sold when interest rates were very low (1%). When US interest rates increased many simply couldn't afford the payments. Normal lending criteria were ignored and defaults rose.
Also, there was a sudden change in sentiment. When house prices were rising, builders, banks and buyers were bullish; wanting to believe house prices would keep rising. When house prices fell, everyone wanted to leave market, exacerbating the initial fall.

For more detail - see: Why roof fell in on US housing Market.

Do you think it is the main factor of the economical crisis?

1. A big factor is the subprime mortgage losses. Banks and financial institutions lost huge sums on mortgages that people couldn't pay. Other banks were affected because they had bought repacked mortgage bundles. Banks around the world lost huge sums so they stopped normal lending. This decline in lending has caused lower investment and spending.
2. House price fall. Related to first point. The decline in house prices has caused people to spend less and confidence has plummeted.

See: other causes of current recession

Are there Ways to predict and prevent another huge economical downturn?

Future macro Policy needs to look beyond just inflation and growth statistics. We need to monitor carefully credit and asset prices. We can't allow another unsustainable credit bubble. Even if means forcing banks to ration credit in boom periods. Also, we can't expect to control economy and finance sector just through one policy measure - interest rates.

• See also : Future of Economic policy

What would you do to solve the problem?

There is no magic solution to wave the problem away. It is very important we avoid deflation, even if it means quantitative easing and increasing money supply. Fiscal Policy has an important role as well as the lower interest rates. But, in a way the economy was so highly leveraged that a painful readjustment is necessary to some extent. Hopefully, the crisis will usher in a new period of more responsible lending and banking.

The period 1993-2007 is (was) often referred to as the period of Great Stability. This seems rather paradoxical after the financial turmoil that has gripped the world since everything started to unravel in late 2006, 2007. Yet, on the surface there was a great stability (apart from short lived panic from the dot com bubble in 2001)

Why was this period Known as The Great Stability?

In recent history the UK had experienced 3 painful periods of boom and bust economic growth. Periods of high inflation were followed by painful recessions:

Previous UK Recessions

1974: 1.4% fall in GDP
1975: 0.6% fall
1980: 2.1% fall
1981: 1.5% fall
1991: 1.4% fall

Annual GDP figures by market prices (Source: Official for National Statistics)

The UK developed a reputation for the 'boom and bust cycle'

It seemed that high inflation was the cause of macro economic instability. If we allowed inflation to increase it caused a boom and bust. Therefore the idea was that if we could prevent inflation we could prevent recessions.

After trying Bretton Woods (upto 1970s), Monetarism (1979-1984), ERM (1990-92), we finally moved to inflation targeting and gave independence of setting interest rates to the Bank of England.

Everything seemed to work well. The UK experienced the longest period of economic expansion on record. (1992-2007) and inflation stayed close to the government target.

The government even brought public sector borrowing down from a peak 73% of GDP in the 1970s to 29% in 2003. The government lost no opportunity to pat themselves on the back and share the very impressive economic statistics with anyone who cared to listen (and even those who didn't particularly want to.) It appeared we had broken the 'inflationary boom and bust cycle'

So Why Was this Great Stability so Instable?

Using statistics of inflation, unemployment, growth and government borrowing, the economy was doing well. In the past this had been sufficient to maintain a stable growth. However, the macro economic stability hid a growing financial instability.

• Asset prices rises well above inflation - primarily house prices. This rise in house prices exacerbated a boom in lending.
  
• Bank Lending becoming based on riskier models. e.g. Northern Rock, RBS e.t.c
  
• Growth of financial derivatives which helped hedge risk. But, actually caused a build up of more risk
• Decline in bank reserves as banks borrowed on money markets to lend new mortgages.
• In short there was a credit bubble. Credit was made cheaply available to a new range of customers. This encouraged high levels of debt, low levels of personal saving and an unbalanced economy.
• Inflationary boom and bust cycles had been replaced with a credit boom and bust.
• Also, it should be said, the economic statistics were impressive. 17 years of economic growth is not based on a complete illusion. The causes of this very deep recession are global and we would be in recession even if the UK credit bubble had been less.
  

Problems in Economy

• Policy makers underestimated how much asset bubbles could effect the economy
• Very few realised how the new bank lending practises and balance sheets could be so destabilising for the economy.
• Economic growth was unbalanced - dependent on rising house prices, low saving rates and high personal debts.
  

Faced with these developments in the finance sector. The old measures of economic stability have proved to be insufficient. Policy makers paid too much attention to headline figures like inflation and growth and ignored seemingly less significant statistics.

Future for Macro economic policy

1. Greater weighting to credit and asset prices in macro economic models
2. A greater flexibility in macro policy making. The models which worked in the past and even at present moment (e.g. inflation targeting) can become insufficient in the future.
3. More policy instruments. Interest rates alone are insufficient to deal with growth, inflation and asset bubbles. Increasingly policy makers see the need to force banks to ration credit in a boom building up reserves for a recession.

One of the causes of the credit crunch was the failure of banks to appreciate the level of risk they were taking on.

In the great boom of the 2000s, banks took on more risk, and with increasingly complicated financial derivatives they felt they were able to hedge against the risk. There was such confidence in the pricing of risk that the cost of taking on risk fell. This of course encouraged financial institutions to sell more risky (i.e. subprime loans) and increase the amount of risky assets in the market. It is easy to be wise after the event. But, the Bank of England produced reports in 2006 and 2007, warning of the dangers of the risk banks were taking.

But, even the Bank of England didn't have the confidence to push this agenda further. One feels that this period was characterised by a 'herding' effect. Because everyone was behaving in a certain way, it encouraged people to feel it must be OK. It's similar to the effect of the dot com bubble - because everyone else is buying dot com shares it must be OK. There is an element of human psychology - the majority must be right. But, unfortunately this is often not the case - as we are painfully appreciating now.

This is from a recent speech by John Gieve – Deputy Governor for Financial Stability 19th Feb 2009

One weakness in the system was the failure of banks and many other investors to appreciate, price and manage risk. It was not that banks were blind to the froth in financial markets. The Financial Stability Reviews in 2006 and 2007 and highlighted the declining price of risk, the build up of global imbalances, the growing dependence of banks on wholesale funding, and the risk that structured credit markets could seize up in a downturn. When we took that message to Chief Executives of banks in London and New York, they generally accepted the analysis and agreed that a correction was bound to come. However, almost to a man
(and they were all men), they took comfort from the sophistication of their risk management systems and hedging strategies. They were confident they could ride out the storm.

But as it turned out their systems were preparing them for a shower not for a hurricane. The limitations of their risk models were cruelly exposed in August 2007. One CFO remarked last year ‘We were seeing things that were 25-standard deviation moves, several days in a row’, which in plain English means that according to their models, the outright impossible was happening on a daily basis...

• From: Bank of England
• Risk Management

Warren Buffet recently quipped that investing in mattresses could be one of the best investments of 2009. (mattresses are a good place to hoard cash in a period of deflation)

He will probably be regretting he didn't take his own advice, after his own investment fund lost a record $11bn. Buying $235m shares in two Irish banks didn't help. Warren Buffet was also caught out by the sharp drop in oil prices we saw in the last half of 2008.

It just shows that even the greatest investors are struggling in this era of great instability. It will be difficult for him to recover these kind of losses given the continued problems in the global economy.

Related

• Good investments for 2009
• Warren Buffet fund down $11bn
  

"Owners of capital will stimulate the working class to buy more and more of their expensive goods, houses and technology, pushing them to take more and more expensive credit, until their debt becomes unbearable.

The unpaid debt will lead to bankruptcy of banks, which will have to be nationalised, and the State will have to take the road which will eventually lead to communism"

Karl Marx, Das Kapital, 1867

Karl Marx, maybe 150 years late, but he does provide a depressingly concise explanation of the credit crunch.

However, you try to dress it up, the nationalisation of the banking system in UK and US (1) represents a colossal failure for the global financial system. Whether governments can do a better job at managing banks is not guaranteed. But, it is a painful blow for advocates of free market forces.

Defenders will say the financial crisis is not entirely due to unrestricted free markets. The US government, through Freddie Mac And Fannie Mae were keen to lend mortgages to a new generation of homeowners and this encouraged a build up of subprime mortgages. In many respects the government regulators failed to adequately deal with the growing problem of risk, toxic debts and a booming asset bubble.

But, it is hard to look at the crisis and not come to the conclusion that the private banks failed their shareholders and failed the general public. The free market mantra that the economy will maintain full employment and provide the most efficient distribution of resources seems a far fledged dream.

Back in 2006 and 2007, the Bank of England published a Financial stability review outlining booming asset prices and declining cost of risk. Banks generally ignored it and the Bank of England lacked the confidence to pursue it to policy changes. Probably by the end of 2006 it was too late anyway.

Now have a chance to rebuild a banking system putting into place safeguards for responsible lending and banking practises; there is no guarantee that government management will be any better. But, one hopes that many important lessons have been learnt from our present difficulties - and if we're lucky we might just avoid the Communist state Karl Marx predicted all those years ago...

• Mistakes of the Banks
• Financial mistakes of the naughties and nineties

(1) The US is dithering about bank nationalisation but it looks increasingly unlikely however much they try to avoid it.