Between now and the general election, the government is planning tax rises of close to £10bn. Mostly these tax rises involve the ending of previous tax cuts.

• The 2p rise in petrol tax, which was delayed when oil prices were high last year, will come into effect Sept 1st.
• The car scrapage scheme will be phased out by Feb 28th 2010
• The 2.5% reduction in VAT will Jan 1 2010.
• 50% Income tax rate will be introduced April 1st
• End of Stamp Duty on houses less than £175,000 Jan 1st

Given the size of the government's budget deficit it makes sense for tax cuts to be reversed, at some stage. These tax cuts were supposed to be temporary in order to boost spending in a depressed economy. Recently, we have seen signs of recovery and though the economy is still far below full capacity, at least some of the fiscal expansion can be reversed.

The danger is that if the recovery is more fragile than many hope, the tax rises could snuff out the nascent recovery and plunge the economy back into a double digit recession. In 1937, the US economy was plunged into a second period of economic downturn after the government increased tax and tightened monetary policy too early.

Nevertheless, despite this fear, I feel the economy should be able to weather these tax reversals. Recent evidence has shown some positive signs. Whilst higher taxes will reduce consumer spending, monetary policy will be able to remain loose to maintain economic expansion. - Interest rates are still close to zero and the Bank of England has shown willingness to continue quantitative easing.

The only problem for the taxpayer is that these tax increases (£10bn) are still a drop in the ocean for the underlying structural deficit. Unless we experience above trend growth, more fiscal tightening will be required after the general election.

As an economics teacher, the most frequently asked question by my students is (apart from can I have more time for my homework?) - Why did you become a teacher, when you could have gone to the City and earned lots more money?

Well, three pretty good reasons for being a teacher are July, August and December. This August holidays, I am in the US again, so posts may be limited over the next week.

When I finished University, I had a pretty good idea what I didn't want to do. Quite high up on the list was working long hours in an office - whatever the monetary renumeration may have been. Therefore, I choose a type of teaching which enables part time work. Basically, in my case I placed a higher value on leisure time than most of my fellow graduates. Later, I felt a certain smug satisfaction as they recounted how they found themselves working a 70 + hours a week in their law firm and having no time to spend all the money they were earning.

We always have choices and there are certainly drawbacks to choosing lower paid jobs. But, as I try to teach my ambitious students, maximising their quality of life is not necessarily synonymous with finding the highest paying job...

With the German economy having declined by 6% since 2008, it came as welcome relief to see a modest growth in German GDP during the last quarter. France also showed a modest economic recovery in the last quarter.

Germany has benefited from the renewed Chinese growth and investment and their own fiscal stimulus. After their finance minister openly criticised Keynesian expansionary fiscal policy, Germany pursued it anyway. IMF figures show the German fiscal expansion was larger as % of GDP than US.

Yet, the sluggish Euro area recovery is hardly cause for celebration. The peripheral areas of the Euro struggle with the hangover from their housing bubble bursting. Countries like Italy, Ireland and Spain are still showing a decline in GDP and are struggling to find an engine of growth since the collapse in their construction and housing sectors.

Given the nature of Euro monetary policy, there will be concern over the development of a two speed recovery.

Both Germany and France were relatively unaffected by the bursting of the housing bubble. As global growth picks up, their economies could retain to a normal pattern of growth and inflation. This is likely to cause the ECB to raise interest rates to maintain its strict inflation targets.

However, whilst a rise in interest rates and a strong Euro may be suitable for Germany and France, they could prove devastating for the peripheral Eurozone member countries, still struggling to recover.

There will be difficult choices facing the ECB in coming months and it is uncertain which will gain the highest priority - recovery in Spain, Italy e.t.c or keeping inflation low in Germany and France.

In an era of rising budgets deficits, an important question to pose is how much can governments borrow?

Typically, higher government borrowing raises these issues:

• Higher borrowing leads to higher interest rates as governments need to attract more people to buy bonds. This rise in interest rates is known as financial crowding out and can lead to lower growth.
  
• Higher borrowing leads to higher taxes
• Higher borrowing can create inflationary pressure, if the borrowing is financed by increasing supply of money.
• Higher borrowing can risk destabilising the exchange rate if markets fear there is a real inflationary pressure.
• Higher Borrowing can cause resource crowding out because the private sector has less funds for investment because it is holding more government bonds.

However, some of these textbook problems often do not occur in reality. - especially, when the economy is in recession and private saving rates are rising.

As Brad de Long notes (link), in the past 12 months, the US treasury has extended its marketable debt liabilities by $2.5 trillion (equivalent to 20% of all US equities) - yet, despite this huge rise in government borrowing, there has been practically no increase in interest rates.

Why Can government borrowing increase without causing Higher Interest Rates?

The reason is that in a recession, firms and individuals want to save. They also want to save in 'safe havens' of the bond markets. Thus the government deficit is mopping up the rise in private sector savings.

When growth is high demand for investment and loans is high, pushing up interest rates. When growth is low or negative demand for investment and loans falls. This pushes down interest rates.

Thus, as Paul Krugman notes, in the US we see an inverse relationship between budget deficits and interest rates. A budget surplus is consistent with high interest rates and a large budget deficit with low interest rates.



Does this mean we can borrow as much as we want?

Well no. The demand for government bonds will be high in a recession, but as the economy recovers, investors will be switching into more risky investments like equities and corporate bonds. As the economy recovers, demand for loans increases pushing interest rates back up.

Therefore in the depths of a recession, governments find it relatively easy to borrow. But, if the high deficits persist during economic growth, that is when we will see upward pressure on interest rates and the possibility of crowding out.

At the end of 2008, some were fearing a collapse in the Pound, suggesting it was finished as a currency. I felt these fears were exaggerated. (Run on the Pound - What's the Panic?) (Is Pound collapsing?) True, the UK economy has significant problems, but, the UK is hardly unique in facing high government borrowing, a deep recession and the need to pursue quantitative easing. At the end of 2008, I felt the Pound would stabilise and recover a little. There were good reasons for the weak pound in 2008, but, they had been overdone.


In 2009, the Pound has recovered, showing that even economists can be right occasionally. Now the Pound has recovered, it is closer to its fair value measured against purchasing power parity.

The future outlook for the Pound looks more uncertain. The rise of the pound this year was hardly a reflection of underlying strength of the Pound. It was more due to the relative weakness of the other countries.

With France and Germany showing signs of emerging from recession, investors may start switching back into Euros as they benefit from the greater security the Euro offers. So far, the UK has been able to sell its public debt without causing too much angst in the financial markets, but, if we continue to have budget deficits of over 10% of GDP, that may soon change.

I feel the Pound will remain relatively weak in 2009 and 2010, which is at least good news for the UK tourist industry and export industry.

Definition Pound Sterling ERI = Pound Sterling Exchange Rate index. This measures the value of the Pound against a basket of other countries. It is trade weighted which means it places greater emphasis on currencies which play a greater role in UK trade

Figures for money supply growth have a history of being unreliable. In the early 1980s, the UK's experiment with monetarism was effectively abandoned after the link between money supply growth and inflation was much looser than text models suggested. However, the slow growth of money supply is an indication of the continuing difficulties in bank lending. It is also an indication why the Bank of England have continued with the policy of quantitative easing.

Graph of UK M4 Annual Growth


See also:

• Link between money supply and inflation.
• Money Supply growth
  

For a more dramatic illustration of the state of the economy, GDP statistics show the depth of falling output.


As mentioned in the previous post - outlook for UK economy. GDP growth is expected to reach a record 12 month annual fall of 5.5% this year.

Given the fall in GDP, it is hardly surprising that unemployment is increasing in the UK

Graph of Unemployment Rates

It is a difficult time for economic forecasting. At the start of 2008, many economists were predicting only a mild slowdown. The scale of the recession took many by surprise. It seemed that whenever the worst was over, more unexpected bad news came along.

Given the parlous state of the economy at the end of 2008, expectations were pretty low for 2009. Given the dismal expectations at the start of the year, things have not turned out quite as bad as the worst forecasts. This does not mean the economy is doing well. It just means, that it could have been a lot worse. (for example, markets were recently cheered by the fact US unemployment only rose 0.5m last month - they expected a lot worse)

Forecasting for 2010 is difficult given the mixed signals still coming from economy. Despite the recent positive news, it seems the Bank of England is still fearing deflation and a Japanese style double dip recession. Their recent message pulled no punches saying this is one of the worst recessions ever. Mervyn King said:

“We’ve been through an extraordinary financial crisis... One doesn’t need to ask questions about 'the worst since when’ since it may be hard to find any period in which it was actually worse.” (link)

On the back of news that GDP is likely to fall by a record 5.5% this year, it is understandable why the Bank of England has extended the policy of quantitative easing.

Why Fears of Japanese style prolonged slump.

Manufacturing output has tentatively picked up. However, this is to be expected after inventories slumped during the worst of recession. It remains to be seen whether this improvement in manufacturing output is sustained or just a reaction to low inventories. The fall in GDP of 5.5% in 2009 is the steepest in the post war period and there is a large amount of spare capacity - indicated by rising unemployment.

The Economy is being propped up by unprecedented government and monetary policy intervention.

• Large Budget Deficit (e.g. Tax cuts which are due to expire)
• Zero interest rates
• Quantitative easing
• Bailout of banks
• Weak Pound
  

However, in 2010, there is little, if any, room for fiscal expansion. In fact the government may face the tricky task of reducing borrowing during a fragile recovery. Also, 2010 will see the expiration of 15% VAT and other tax breaks. It remains to be seen whether consumer spending will hold up after these sweeteners are removed.

Many fear, if interest rates are increased too quickly, the economy could be plunged back into recession. Arguably, this is what occurred in 1937 and in Japan in their 'lost decade'

Some of the 'positive signs' are also potentially misleading. The recent bounce in equity markets may help confidence but, it's hardly an economic fundamental.

One promising sign is that house prices appear to be stabilising - admittedly on extremely thin levels of mortgage approvals. But, stability in house prices will be important for the British consumer nervous about spending. But, the stability in prices could still prove to be short lived.

The prospects for 2010 therefore depend on the attitude of Central Banks and governments. It appears the Bank of England is more concerned with deflation than inflation and they have stated they will do everything to avoid a prolonged depression. This indicates interest rates could remain low for a protracted period. (I wonder whether the prudent ECB will have sufficient flexibility to put aside their long standing anti-inflation concern and keep rates low.)

My personal feeling is cautiously optimistic. I think things will get better. But, that doesn't mean we will see a return to a period of rapidly rising living standards. As the Bank of England point out, the next few years will see a period of economic austerity as bank lending and consumer spending remain subdued. Also, tax rises and spending cuts are quite likely in next few years.

Forecasts For Interest Rates

The Bank of England suggest interest rates could stay at 0% for the first half of 2010.

Forecasts for Inflation

The Bank of England suggests inflation could go below its target of CPI 1-3%. There is no sign yet of inflationary pressure from quantitative easing or a weak pound

Forecasts for Growth

Growth will be positive in 2010, but still below the trend rate

Forecasts for Unemployment

Unemployment may peak below 3 million. But, although unemployment increased slower than forecast, it may take a lot longer to decrease. Also, many workers are facing prospect of having to take on part time work.

Related

• Causes of Economic Crisis
• Bank of England Inflation report

The Great Depression and the failure of classical economics to provide a solution led to the rise of Keynesian economics. In particular, an active fiscal policy to maintain full employment was a key element of the post war consensus.

However, many felt that the 1970s, proved the failure of Keynesian economics. Against a backdrop of stagflation, neo-classical economists such as Milton Friedman came back into fashion and this led to the adoption of Monetarist policies in the early 1980s - in both US and UK.

However, was the 1970s such as failure?


Inflation did rise significantly. This was a combination of

• An external shock - rise in oil prices
• Monetary policy too loose
• Wage price spiral magnified by relatively powerful trades unions.

Despite the high inflation, living standards did rise during the decade.



Unemployment did rise in the 1970s, but, it was much lower than the unemployment experienced during the 1980s.

There was a break down in the simplistic Phillips curve showing a trade off between inflation and unemployment. However, given the external supply shocks this is only to be expected. You could argue the Phillips curve merely shifted giving a worse trade off.

In response to the inflation of 1979, governments in both UK and US adopted Monetarist policies - tight monetary and fiscal policy. This caused a deep and long last recession 1979-81, with rising unemployment. In the UK, unemployment rose to over 3 million.

According to the rational expectation, real business cycle models advocated by Monetarists, the recession should have been much more short lived. But, it wasn't, in the UK unemployment rose to over 3 million for a considerable time.

Despite this failure of Monetarism in the early 1980s, the ideological strength of laissez faire remained untarnished and this led to the widespread growth of financial deregulation which has caused so many problems in the current climate.

Many commentators refer to the current downturn as the worst economic situation of the 1970s. But, this is incorrect, the current economic downturn is far worse than anything witnessed in the 1970s. Unemployment is rising at a much faster rate. Output is falling far deeper and for longer. True, we don't have the instability of high inflation, but, inflation is not the most pressing concern at moment.

There were many structural weaknesses in the 1970s - powerful unions, reliance on oil imports from OPEC. But, the inflation of the 70s was not 'proof' that free markets will provide optimal solution. To say the 1970s 'proves' the failure of Keynesian economics and government intervention in the economy is very lazy analysis.

• Keynesianism vs Monetarism

• Economics of the 1970s

We have witnessed the worst contraction in bank lending for many decades. Mortgage lending has slumped as banks have retreated into their shells, trying to recoup their bad losses. The recession is also one of the most severe since the 1930s, with output falling by a record level in early 2009. Yet, despite the economic slump, house prices appear to be stabilising with the unexpected prospect of finishing the year higher than they started.


True house prices have fallen 25% since their peak. But, they could hardly be described as cheap. Looking at First time buyer affordability. They are much higher than in the post 1992 slump.

House Price to Earnings Ratio for First Time Buyers


The house price to earnings ratio for first time buyers is still over 4.0 Compared to 2.2 in 1994.

Looking at Mortgage Payments there is a similar story


Furthermore, it is not even clear whether first time buyers are any better off now than in 2007. Affordability has increased a little, but banks are now requiring much bigger mortgages. In practical terms, many first time buyers are still struggling to get on the property market.

Also the fall in real house prices is less than in the post 1989 boom. With inflation close to 0%, the real fall is similar to the nominal fall. Unlike in the early 1990s when inflation meant the real fall in prices was higher.


Real House prices fell 36% from 1989 to 1995

Reasons House Prices have stopped falling

Very Low interest rates.

With base rates at 0.5%, many homeowners are reaping an unexpected bonus of cheap mortgage payments. It is a complete contrast to the last boom when interest rates were in double figures. Admittedly, many banks have not passed the whole base rate onto consumers, and fixed rate mortgages are much higher than base rates; but, by historical standards mortgage payments are low.

Shortage of Housing.

The volume of housing transactions is very low. Mortgage lending is well below its 2007 peak. Demand is thin, but, so is supply. It is the fundamental shortage of supply, which is keeping prices artificially high.

The housing slump has led to a record low of house builds; it will take several years for the housing stock to increase. Therefore, in the next couple of years house prices are likely to determined by this continuing shortage of new houses for sale.

In countries like the US and Spain there is a surplus of housing stock and this explains why there house price fall is much greater.

The stability in prices will encourage more mortgage lending. With house prices falling, banks require much bigger deposits. But, with stability in prices, we are likely to see a decline in the necessary deposit. This could help first time buyers struggling to get a mortgage

However, maybe it is too early to call an end to the house price slump. Demand for houses is still thin. Unemployment is continuing to rise and banks are still reluctant to lend. The ratio of house price to earnings will give little comfort to those hoping to buy their first house. Looking at the last housing slump, prices remained in the doldrums for nearly 4 years. Nevertheless, it is still interesting to see Halifax 3 month measure showing a positive rise for first time since 2007.

More housing statistics - Housing Market.org

• Overvalued housing markets
• Impact of housing on Economy

Against a backdrop of very low housing activity, UK house prices appear to be stabilising.
During periods of house price falls, there are often monthly aberrations. However, the Halifax three month trend showed its first positive rise (of 0.8%) since 2007. This suggests that the most pessimistic house price forecasts for 2009, now look too bearish. The Institute of Chartered Surveyors have now changed their forecast from a fall of 10% to a small rise.

Mortgage lending in June also showed a small increase. But, it remains far below pre 2007 levels. This indicates a house price recovery is based on the very low interest rates and continued shortage of housing, rather than a renewed enthusiasm of banks to lend mortgages.

Quarterly Mortgage Lending Statistics

Statistic for Monthly UK Mortgage Lending

Monthly Figures for Recent Mortgage Lending. Source: CML

Related

• Long Run Prospects for UK house prices

After narrowly avoiding the need for Government bailouts, Barclays posted profits of £2.98bn in the first six months of 2009. HSBC also posted profits of $5bn in the first 6 months. This growth in profits was despite a rise in bad debts. International bad debts at Barclays rose from £2.54bn to £4.56bn. The best area of growth was from investment banking. Retail banking is still struggling from recession and rise in mortgage arrears.

Whilst these two banks didn't get direct funds from the government, they have benefitted from the taxpayers guarantee to the banking system. The government has agreed to underwrite the whole banking system with guarantees of over £100bn. Quantitative easing has also helped maintain liquidity at a time when interbank lending froze up.

Critics of the banks will say that there reckless behaviour created a crisis which required taxpayers to bail them out. Despite the record bailout, it wasn't enough for the banks credit crisis to avoid the deepest recession since the 1930s. Furthermore as the unemployment rate continues to rise, banks are going back to seven figure bonuses and making high profit.

"plus ça change, plus c'est la même chose"

There is also concern that the taxpayer bailout may give banks a false sense of security and in the long term, could see a return of risky / poor investment decisions which saw the previous credit crunch.

Also, there is concern at the increased monopoly power in the banking sector. The margin between lending rates and saving rates have increased, helping to raise the profit margin for banks at the expense of the consumer.

Typically, banks will say high profit is the sign of healthy business practises and that these profit levels are a good sign that the banking system, the UK's most important industry, is showing a return to profitability.

In one respect, the high profit of banks is good news. It makes taxpayer guarantees safer. It should, in theory, help to encourage more lending to private firms and individuals. The profit levels were certainly well received by sterling and the stock market, both of which rose yesterday.

Yet, it would be easy to forget the real source of the current economic crisis, and rising public sector deficit. Bank profit is not necessarily a bad thing, but, given the scale of taxpayer bailout of the industry, we have every reason to scrutinise the performance and profit of the banks.

Of course, the banks owned by the government are a different story. Northern Rock, posted losses of £724m in the first 6 months. But, that's OK, because the taxpayer was there to bail them out.

It just shows the old adage in banking - heads you win, tails the taxpayer loses.

In US, banks bailed out by the government are also experiencing large profits, including profits from clever investment practises.

Related

• The Problem with Bank Bonuses
• Difficulty of Bank regulation
• Mistakes of banks

Rewarding Bad Actors - Paul Krugman at NY Times

Wall Street Profits from Trades with Fed at FT

Readers Question: Have we addressed the core reasons for this economic downturn?

The core reasons for this economic downturn:

• Credit Crunch - bank losses and consequent decline in bank lending
• Falling House prices
• Falling consumer spending due to confidence and declining asset values

Credit Crunch. The main reason for the severity of this current economic downturn was the funds lost by banks in various subprime lending schemes. The huge losses by major banks led to a restriction of credit harming ordinary economic activity.

To some extent this has been addressed through painful and expensive government bailouts. For example, in the UK, the government have increased public sector debt by £141bn due to financial sector bailouts.

These bailouts helped to calm the panic that was threatening the markets. But, normal lending conditions have still not returned. There is also concern that banks may have more losses to write off - especially as house prices continue to fall and the recession leads to an increasing number of bankruptcies.

2. Falling House Prices. The turnaround in house prices has been dramatic. After rising at above inflationary trends, house prices have been falling in US since 2006 and in the UK since mid 2007. This fall in house prices caused a decline in consumer wealth and consumer spending.

There are signs that the fall in house prices has moderated. The UK has seen some positive monthly house price rises. But, these price rises are on thin trading volumes; it hardly reflects a return to the pre- 2007 levels. Also, in other European countries such as Spain and Ireland, house prices could have much further to fall. In overvalued housing markets, we saw how US house prices were far from being the most overvalued. If European house prices continue to fall, it could cause a rise in bank losses, which will cause further problems

3. Fall in Demand. The combination of a fall in house prices, decline in confidence and collapse in bank lending has led to a fall in aggregate demand in the economy. This has been maintained by low interest rates and large scale government budget deficits. However, we can't keep relying on ever increasing budget deficits to boost the economy. By addressing the core problems we have created another problem - very large levels of government borrowing.

See also:

• Financial crisis explained
• Credit crisis