On the way back from holiday in Ireland, I picked up a copy of 'Dear Under Cover Economist by Tim Harford and really enjoyed reading through the questions and answers.

There is a range of everyday questions, related to economics.

For example,

• Why do People wait outside train doors delaying people getting off when they would be better giving more space?
• Is it worth paying for municipal car parking charges when the chance of getting fined for not paying is low?
• Why Should I wash my Car? It will be dirty tomorrow?
• My girlfriend never orders cake for dessert, but, then always eats my cake that I order - what should I do?
• In restaurants, my husband always chooses better items than me, but, it's boring to always choose the same as him. What should I do?
  

The answers all use some kind of economic theory from the prisoners dilemma , to income life-cycle hypothesis and rational expectations hypothesis. It's all an entertaining way to express everyday lifestyle questions in economic terms. It creates a good mixture of entertainment and enlightenment - a playful guide to everyday living.

• Dear Undercover Economist at Amazon.co.uk

The outspoken chief executive of Ryan Air, Michael O'Leary, has slammed the governments Air Passenger Duty tax, which will go from £10 to £11 in November. He cites this as a major reason for reducing the number of flights from Stanstead. He claims the tax is unfair and bad for the airline industry.

We could say there is a certain hypocrisy in the Ryanair approach. After all they are the masters of adding extra charges, such as charges for buying with credit card, charges for extra bags e.t.c.

Ryanair defend their charges by saying they encourage more efficient flying. I agree. I think it is an excellent way to charge passengers. It means you don't pay for meals you don't like. It means you don't pay for wine you don't want to drink. It encourages people to check in online and reduce baggage. It is an admirable business model and an economist would like the way it increases allocative efficiency by charging according to the marginal cost of extras.

However, the target of an airline tax is to also encourage greater social efficiency. Flying has significant negative externalities to society. Global warming from pollution, noise pollution e.t.c. Therefore, this pigovian tax is a way of making people pay the social cost of flying. Given externalities involved in airline travel, I think you could make a good case for saying the airline tax should be significantly higher.

Unfortuantely, many other European countries have dropped the tax, which means they are free riding on the UK's attempt to reduce global warming by properly pricing airline flights. But, just because other countries do the wrong thing doesn't mean we should give into bulling by the air industry.

BTW: I will be away next week. I am flying to Ireland (by Ryanair of course) for a cycling holiday. The actual flight cost about £10. But, I ended up paying over £100, which included £60 for the privilige of carrying a bike! Good old Ryanair!

Related

• Ryanair ticket prices

I Updated page on National Debt. following yesterday's grim figures (though some feared they could have been worse)

• Including the financial sector intervention, public sector debt rose to just under £800bn or 54 % of GDP.
• Excluding financial sector innovation, public sector debt is £657.5 billion or (46.6% per cent of GDP)

National Debt may still lower than many other countries, but markets are alarmed at the pace of the deterioration in public finances. Significant portions of tax revenue have just evaporated and show little signs of returning.

Needless to say, this rapid deterioration in public finances leaves any government little room for maneouvre. It will be a difficult balancing act to reduce borrowing without snuffing out any nascent recovery. However, at the moment there is no hope of reducing borrowing, figures suggest a remorseless rise in government borrowing over the next 2 years.

The ratings agency Standard & Poor's has put Britain's prized AAA rating on credit watch with a negative outlook. This is often a precursor to reducing a credit rating. A lower credit rating would make it more difficult and expensive for UK to borrow in future.

To finance government debt, governments sell bonds which pay interest (yield). E.g. a government may sell a £100 bond at an interest rate of 5%.

These bonds could be held to maturity anything from 3 months to 30 years. However, many bonds are bought and sold on financial markets causing price and yield to change. The price and yield of bonds give various indications of the state of the economy.

Firstly, if bond prices rise, yields decline. If bond prices fall, the yield rises. There is an explanation why here.

• Since last autumn the yield on the 10-year US Treasury bond has risen from just over 2pc to almost 4pc.
• UK Bond yields on 20 year and 30 year bonds are currently 4.75% (source: Government bonds at Bloomberg)
  

Thus rising bond yields means investors are less willing to hold government bonds. More people are selling bonds causing price to fall and yield to rise.

Why Bond Yields are Rising.

Bond Yields can rise for a variety of Reasons.

1. People prefer riskier assets such as shares. (the recent rise in the stock market suggests some are switching from safe bonds to riskier shares)

2. There is fear of future inflation. If investors expect inflation to increase in the future, they will demand a higher interest rate (yield) to compensate for the decreased value of money in the future. Higher inflation may be feared because of:

• economic recovery
• Oil price shock.
• Quantitative easing to increase money supply

3. There is fear Over Government Ability to Repay debt. If investors start to doubt the safety of government debt they will require higher interest rates for the risk premium. This is a cause for concern government debt around the world is rising sharply, if markets worry governments are too indebted, yields on debt will rise making it more expensive to finance.

4. High levels of debt High levels of debt tend to reduce yields as more bonds are sold onto markets. The policy of quantitative easing is buying up some of these extra bonds. In theory this should push up prices and push down yields. But, quantitative easing also raises inflationary expectations.

Should We Worry about Rising Bond Yields?

• In a recession with a threat of deflation, bond yields are very low. If Rising bond yields are a sign of economic recovery and a return to normality, then this is a good sign.
• The aim of quantitative easing is to avoid deflationary pressures, therefore, if it is successful in avoid deflation and pushing inflation to more normal levels again we would expect this to have an effect on bond yields.
• If rising bond yields are because the government's credit rating is deteriorating, then this is a real cause for concern. It means it will be more difficult and expensive for governments to finance their large budget deficits in the future.
• Higher bond yields may push up long term interest rates on corporate bonds and mortgages. These higher interest rates will have the effect of slowing down economic growth and investment.
  

The big question is then are rising bond yields due to economic recovery or worries over government debt? At the moment, the markets are giving the governments the benefit of the doubt. Although bond yields have risen from the record lows they are still relatively low by long term standards. However, with future deficits expected to be very high, this could change in future.

Related

• Problems of government borrowing
• Rising bond yields highlight fears over Government debt at Telegraph
• Rising Bond yields point to Economic recovery at Independent
  

I have to admit to a certain 'pandemic fatigue.' Previously, many threatened pandemics reached front page news only to dissipate and never materialise. Yet, a report by Sir Liam Donaldson, the Government's chief medical officer, suggested that this current Swine Flu really could reach pandemic proportions, with up to 100,000 cases a day. The report assumes that infections will ultimately reach 50pc, with a mortality rate of 0.4pc. If the virus did become this widespread it would have serious economic consequences for a fragile economy.

Economic Effects of Swine Flu.

Lost Output. Workers will take time off because of the flu. Schools and other large public bodies could start to shut down to try and prevent a rapid escalation of the disease. This would lead to lost output and lost GDP.

Lower Demand. A widespread flu pandemic would curtail spending on certain items, especially luxury goods such as tourism and flights. This would not just be from those with the disease, but, friends and family.

Impact on Confidence. Swine flu is already front page news, despite a low infection rate. If the swine flu really takes off it could dominate news and adversely affect people's confidence to spend and invest. We are likely to see an extended paradox of thrift as people.

Deterioration in Public Finances. Lower growth and output would further hit the beleaguered public finances leading to an even larger deficit.

This year, according to the governments budget, GDP is expected to fall 3.5% - one of the largest drops on record. With this level of economic decline any further loss of output is to be deeply regretted. A report by Ernest and Young into the impact of a relatively modest case of swine flue could cause this output to fall by a catastrophic -7.5% [link Telegraph]

It is hard to quantify the economic effects of swine flu, because it is a relative unknown. Some point out that the number of fatalities from flu, is unlikely to be much worse than a typical year. But, if places of work close down and people change their spending habits, it would be a real kick in the teeth for the end of a difficult year in economics.

Just a follow up from last week's post on the costs of an ageing population. A reader wrote that they would be happy to work longer, but, many firms are reluctant to hire 'older workers'

Simply firms will have to change and become more willing to hire older workers. At the moment, the recession and high unemployment gives them a large choice. But, if demographic changes continue, there could be acute labour shortages unless firms are more flexible in keeping on older workers.

I imagine there will be greater flexibility, rather than going from full time work to full time retirement, there will be greater use of part time older workers.

Interestingly some firms like B&Q and McDonalds have found that employing older workers has many benefits in terms of reliability and gaining the trust of consumers. These benefits offsetting the perceived inflexibility of older workers in learning new skills.

In the current climate it's a tough environment for those approaching retirement age to find work, but, I see this situation changing in either the near or distant future.

In previous posts I have discussed the different approach the ECB has taken to this great recession.

In summary, the ECB have been more conservative in their response.

• Interest rates fell slower
• Reluctance to engage in quantitative easing.
• Still worried about inflation despite the depth and scope of the recession.
• conservative response has kept value of Euro higher, but, this has made it more difficult for Euro exporters.

In part, this stems from the ECB's objectives and history which aims to give a high priority to keeping inflation low. You can see difference between ECB and Bank of England here

However, the IMF states that the EU area now faces one of its sharpest ever slowdowns (Output is forecast to fall 4.8% this year).

My concern is that the ECB have failed to realise how serious the threat of debt deflation and lower growth is. A genuine fear is whether the ECB have sufficient flexibility and ability to adapt to different circumstances. Unfortunately, Japan does not set a good precedent. A decade of dithering over deflation proved very costly for the economy.

The large fall in output and absence of Quantitative easing has led to a fall in M3 money supply since February. For example, Ireland is facing a huge fall in Money supply of 30%,. This is very damaging for a country indebted as Ireland. With deflation, the real value of debt increases making it more difficult to pay off.

The problem is that members of the Euro are faced with few options.

• They can't devalue to restore competitiveness (like Greece and Spain badly need)
• They can't engage in quantitative easing
• They can't cut interest rates

There only real option is fiscal policy. (As part of the Euro, The growth and stability pact was supposed to limit government borrowing to 3% of GDP and national debt at 60% of GDP. But, this has been ignored as unworkable for quite a long time)

It is not surprising that Government debt in the Euro area has increased as governments try to provide some stimulus to their beleaguered economy.

With birth rates closes to 1.5 in Germany and Italy, and a rapidly ageing population, the future prospects for Euro fiscal deficits look grim.

Many countries are now facing public debt of close to 100%

• Italy - 116pc in 2010.
• Greece is vaulting back to 109pc,
• Belgium to 101pc,
• France to 86pc.
• Germany 82%

UK debt has soared to 55% and is forecast to keep growing by 2010. But at least in the UK, monetary policy has been able to provide some economic stimulus rather than just relying on fiscal policy.

Related

• European Unemployment
  
• Europe digs its grave by Ambrose Pritchard

A few weeks ago, I read an interesting piece in the Economist from Christina Romer, the chairwoman of Barack Obama's Council of Economic Advisers (lessons from 1937)

Basically, it concentrated on the events of 1937 and the double dip recession which occurred.



Most people assume that the Great Depression lasted for the whole 1930s, but, this wasn't the case. Output fell for 3-4 years between 1929-32, but then recovered. By 1936, output was rising strongly. Unemployment was still high, but, it had started to fall.

However, 1937, was a real kick in the teeth as the relatively strong recovery came to an end and the economy went into recession again, causing unemployment to rise above 20%.

This second recession of 1937, was put down to two main factors.

• A tightening of monetary policy. The Fed doubled the reserve ratio required by banks because they became nervous over inflationary pressure. But, this doubling in reserve ratio led to a tightening of lending.
• A tightening of fiscal policy. - Tax increases (social security taxes collected for first time) and spending cuts (veteran's bonus allowed to expire).

Interestingly in 1937, there was great concern over the size of the budget deficit and there was strong political pressure to reduce the deficit. Public opinion generally supported moves to reduce the deficit.

However, this switch in policy, combined with a tightening of monetary policy, caused a recession. And the worst event for the budget deficit is a recession. In a recession, the budget deficit will tend to rise - even if you increase tax rates and spending cuts. A return to growth is one of the best ways to reduce the budget deficit.


This does not mean we should permanently run in a budget deficit because of fear of creating a double dip recession. The governments deficit will not be reduced by a return to normal rates of growth. In the medium to long term, the government will need to tackle the structural deficit.

However, they will need to be careful. There will also need to be a careful co-ordination with monetary policy to prevent a sudden tightening which could push the economy back into recession.

• Lessons from Great Depression
• Myths of Great Depression

Recently, I've seen alot of different shapes to forecast any potential recovery. I've seen claims of a trampoline recovery (W shaped) to a saxophone recovery (quick recovery followed by levelling off.

A trampoline or double dip recovery, would involve a premature recovery, followed by a second decline in output. The argument is that confidence may return because of very low interest rates and the high level of fiscal injection into the economy. This may lead to a temporary recovery. However, this recovery may be short lived because the fundamental problems have not been addressed. In particular, banks are still showing signs of reluctance to lend. Until the balance sheets of banks improve the economic recovery will be limited by lack of funds for investment.

A saxophone recovery, would involve a sharp recovery that runs out of steam. This could occur if spending rises due to very low interest rates we currently have. However, this sharp recovery may cause interest rates to rise. This rise in interest rates to more normal levels would then quickly sniff out the recovery as the temporary boost of low interest rates evaporates. Another factor which may cause the recovery to falter is the pressure on the government to reduce its ballooning budget deficit. Currently, the government is running a huge budget deficit, to help stimulate the economy. Economic recovery may necessitate higher taxes and spending cuts. This could then plunge the economy back into recession. (see: weak economic recovery)

The third option is a nike shaped recovery, where once the economy gets going it creates a virtuous circle of rising confidence, rising house prices, and rising investment. As spending and confidence picks up, the banks may return to normal lending this enables investment to keep increasing. I haven't seen many people predict this kind of recovery. It happened after the last recession. But, that was because the recession was caused by high interest rates, so when interest rates were cut, and the pound devalued, there was a strong boost to the economy.

Two Statistics:

• Housing Starts 70% lower than during peak of housing boom
• Surge in Housing starts as new home builds jumps 17%

Both statistics are true. But, both give completely different interpretations. There is a 17% increase in housing starts, but given low basis, it hardly is much to get excited about.

Also note there was an increase at the start of 2009, only for housing starts to drop back again.

The moral of the story is be wary of statistics. We need to look beyond the headline statistic to understand their context and relative significance.

For example, in the UK, we have seen figures like 15% jump in mortgage lending. But, this is from a very low base. Another way of thinking about the jump is. - Despite zero interest rates, mortgage approvals still close to record lows.

After a deep recession, it is tempting to look for glimmers of hope and build them out of proportion, but, they can be misleading.

Unfortunately, recent revisions to GDP statistics suggested the downturn in the first quarter of this year was worse than expected (often revisions go the other way)

N.B. Understanding the significance, context and importance of statistics is an important skill we try to teach Economics A Level students. Another example is the difference between a fall in prices and a fall in the rate of change.

See also: Misleading economic statistics