The US is facing many economic problems from unemployment of 10%, to the deepest recession on record. This recession has also aggravated levels of US debt. Usually, recessions solve trade deficits. But, the US has still been left with a hefty trade deficit of approximately $500bn.

1. Trade Deficit

The US trade deficit has recently fallen from a peak of 6.5% of GDP to just under 5% of GDP. However, this decreashttp://www.blogger.com/post-create.g?blogID=8487128531050281473e is largely because of the sharp fall in US GDP and world trade, and may prove temporary. The great recession caused an unprecedented fall in American consumer spending, which led to lower imports. But, despite a fall in the dollar and lower consumer spending, the deficit is still surprisingly large. The US trade deficit widened between August and September

One reason for the persistent deficit is the Chinese government's policy of keeping the Renminbi undervalued. They are doing this by buying dollar assets such as Treasury bills. It is these capital flows which are financing the US current account deficit and preventing the Renminbi appreciating against the dollar. The Chinese purchase of dollar assets such as Treasury bills have also helped fund the US budget deficit, something the US doesn't really mind.

But, the problem is that the large US trade deficit reflects a persistent economic imbalance.

To rectify the deficit will require:
Further depreciation in the dollar to restore competitiveness. This decline in the dollar will reduce American purchasing power abroad.
A period of lower spending and higher saving rates.

There are some who suggest that we should not worry about trade deficits in an ear of free capital flows and floating exchange rates. If the deficit is too large, the dollar should devalue and this should help solve the problem. As long as people are willing to buy dollar securities, the trade deficit will be financed. (see: Should we worry about Trade deficit?)

But, what happens if the world's appetite for buying dollar assets dries up? The dollar could fall sharply to rectify the trade deficit. The worrying thing is that the financial / economic crisis has still not tackled the underlying economic imbalances that exist in the world economy.

Related

• Reasons for US Current account deficit
• US China economic relations
• US economic problems
  

Readers Question: Many experts assert that the assumption of ever increasing property prices is the main factor that has led to the credit crisis. Do you think that the events that led to the crisis would still unfold even if all the lending institutions over the world had predicted falling property prices?

Firstly, I'm not convinced that the boom in house prices was the most important factor that led to the credit crisis. In the 1980s, the UK experienced a similar boom in house prices (prices rose over 30% towards end of 1980s) But, despite the boom and subsequent bust, we didn't experience a credit crunch to the same extent.

I feel, the main reason for the credit crunch is that the rapid rise in US house prices was fuelled by unsuitable mortgages. It was the growth in unprincipled lending that led mortgage companies and banks to be exposed to significant losses. (see: Credit Crunch Explained - for more on causes of credit crunch.)

Mortgage companies were lending vast sums to people who had little if any chance of paying back the mortgage when the introductory term ended.

Of course, rising house prices (and the expectation of future house price rises) was a key factor in encouraging companies to lend to all and sundry. The expectation (or let us say blind faith) house prices would rise for ever encouraged:
- Mortgage firms to lend with little scrutiny of affordability / ability to repay
- The monetary authorities played little attention to the housing bubble. In fact they never referred to it as a bubble until after crisis started.

If House Price falls had been predicted would things Have Been Different?

Yes,

One assumes that if lending institutions, knew house prices were going to fall 20% - 25% from 2006, they would never have lent the mortgages they did. It is true some mortgage salesmen were paid on commission, regardless of suitability. But, if house prices could fall, presumably, the lending institutions would have been stricter in giving mortgage salesmen to lend to anyone who asked for a $200,000 loan.

When mortgage companies / banks expect house prices to fall, they become very strict on mortgage lending. They require large deposits and are much more strict on income multiples. If you expect house prices to fall, a bank is not going to lend 100% mortgages, but will ask for a say a 25% deposit. This would have protected banks from mortgage defaults which was the prime cause of the credit crunch. If banks had predicted house price falls (or even seen it as a realistic possibility), they would (should) have made much better decision in lending and avoided the losses which, through CDOs were compounded around the global financial system)

It is difficult to Predict House Prices.

In 2000, few would have predicted how much house prices would have risen by 2006.
At the start of 2006, not many lending institutions were predicting 20% house price falls.
At the start of 2009, few would have predicted the house price rises we are seeing this year.

But, in the 2000s, there was a collective amnesia (especially from those lending mortgages) forgetting that house prices can fall as much as often rise. Examples of Japan, and previous busts were ignored in a good example of irrational exuberance.

If lending institutions were able to predict house prices, they would never have made so many bad loans, which subsequently defaulted causing bank losses across the world.

I don't think it is a question of being able to predict house prices. But, avoiding bubble hysteria and being more realistic about potential house price falls.

I also feel the credit crunch could have been avoided if there was very good regulation of mortgage markets in the US. If the government had abolished self-certification mortgages, and mortgages several times income, then the raft of bad mortgage lending would have been considerably less.

A few weeks ago, I wrote a post about - Better off on Benefits.

It reflects a problem common to many Western democracies. - Many tax and welfare policies designed to reduce relative poverty have the unfortunate side effect of giving low income earners no incentive to get a better paid job / work longer hours.

The reason is that when a worker gets a better paid job, they pay more tax and lose means tested benefits. So there net take home pay is often no better than before. If their take home pay remains the same, we say their effective marginal tax rate is 100%

It is actually quite hard to find statistics which consider the impact of welfare benefits and taxes. Maybe the government doesn't want to publicise how the tax and benefits often create zero incentives. I would guess that most people would assume working longer hours / getting higher paid should lead to higher incomes.

This is an interesting graph showing earned income less taxes, plus a variety of benefits. Note, this is for a typical family of three in Virginia. A single adult would, for example, be entitled to less benefits aimed at children.

Source - Mises.org: which also shows implicit marginal tax rates. Via G.Mankiw
Note: Mises is a right wing think tank noted for its scepticism of government intervention; the example chosen may have been to highlight their point. But, the principle of 100% marginal tax rates is often correct and it does have important implications for policy.

If I had lots of spare time (which unfortunately I don't) I would try to create similar graphs for the UK. But, I have to say, it would be a very time consuming job.

At one stage, it looked as if official unemployment statistics could rise close to 3 million. So yesterday's unemployment figure of 2.641 million suggests the worst may be over. There was a small monthly fall in unemployment. This meant a 3 month rise of just 8,000 - the smallest increase since the recession began. It is encouraging because unemployment is often a lagging indicator - which means that usually unemployment continues to rise even during recovery. A fall in unemployment at this stage is very welcome.

Combined with improving consumer confidence and growing manufacturing output, it gives more credence that last months GDP statistics were wrong and underestimated GDP

In fact many traders and economists are convinced the recession is over and GDP statistics are misplaced

Chris Williamson, the chief economist at Markit, which produced several surveys showing positive economic signs, insisted that the ONS data was wrong. He said: “We think the numbers are wrong. A whole host of indicators other than ours show that the economy grew in the third quarter, powered by a stronger services sector. There is a risk that these figures could lead to disastrous policy mistakes. The ONS has always found measuring the services sector difficult.”

However, as Governor of Bank of England suggests, even a modest recovery is no cause for '"bunting and celebration". Output is still 6% below 2008 peak. Firms and consumers will be engaging in a balance sheet recovery. In other words, we are still trying to repair our past debts hampering spending and investment.

Also, one of the fundamental causes of the recession - the credit crunch - is still hampering business and firms. Banks are still reluctant / unable to lend and are relying on intervention by Bank of England.

Definition of Tobin Tax

• A Tobin tax is the name given to a specific tax placed on currency transactions.
• It was proposed by economist, James Tobin, as a way of stabilising currency markets.
• The idea is that by increasing the marginal cost of currency transactions it reduces the incentive to speculate on currency movements. In theory, this prevents destabilising swings in currencies.
• Tobin initially proposed a tax of 1% on all currency trades. This has subsequently been reduced to lower figures such as 0.25%. One UK proposal suggested a Tobin tax as low as 0.01%

Advantages of a Tobin Tax

1. By placing a tax on currency trades, it makes currency trading slightly less attractive. By marginally increasing the cost of currency trading there should be a reduction in speculative trading, leading to greater exchange rate stability in floating exchange rate systems.
2. Raises Revenue. The global trade in currencies has grown at a very rapid rate. In 2007, the global currency market was worth $3,200 billion a day in 2007, or £400,000 billion per annum. Of this, trade in Pound Sterling as £34,000 bn a year.
3. A tax set at 0.01% on just Sterling trades would raise £2bn a year. A tax on global currency trades could raise significant sums.
   
4. Redistribution from Financial Sector to Developing World. The idea of a Tobin Tax is often seen as a good way to redistribute income from developed world to the developing world. The idea has been seized upon by many aid charities and anti-globalisation protesters. Though James Tobin has often stated that the main purpose of the tax is not about raising revenue and redistributing wealth, but its impact on reducing speculation.
5. After damage created by speculative investments such as derivatives and futures trading. There has been greater support for intervention to reduce speculative buying in financial markets.

The famous investor George Soros has stated, though it would harm him personally, he thinks a variation of the Tobin Tax could be beneficial for the world economy.

Arguments Against Tobin Tax

• Difficult to tax all transactions, it may encourage investors to find ways around the tax.
• Decline in currency flows may harm functioning of markets and lead to poor liquidity in currency markets.
• Tax may be insufficient to prevent speculative flows and currency movements which are driven by economic fundamentals.
• A tax may discourage 'hedging' which is a way of insuring against currency movements rather than discouraging speculation.
  
• If it was introduced unilaterally in one country, e.g. UK then it would lead to loss of financial business as firms trade in other currencies / countries
• There may be better ways to deal with speculation e.g. placing lump sum insurance schemes on financial firms who invest in speculative markets.

At the G20 Support finance ministers in US and Canada were quick to condemn the tax, proposed by Gordon Brown, on the grounds of 'we are not in business of raising taxes'. But, the arguments against a Tobin tax are weak. Why do we happily accept a VAT Rate of 15% on basic goods yet, feel a tax of 0.01% on currency would be damaging and unfair?

A Tobin tax is more than just a measure to tax 'undeserving financial speculators' It is not going to undermine the world economy as some of the more extravagant claims may suggest. On balance, it is a sensible policy with many benefits - both economic and social.

The current recession is the longest recession since records began in 1955. It is the deepest since the great Depression of the 1930s. The fact it could have been much worse is scant comfort.

The economy is being propped up with low interest rates, tax cuts, a weak pound and quantitative easing.

Amidst the gloom, there are some signs of recovery. Manufacturing output rose sharply in September (after a sharp fall in August) Confidence has improved somewhat. New car sales (helped by government's scrapage scheme) have risen by a third. All this suggests GDP statistics for the last quarter might be wrong, and could be later revised upwards. Yet, few expect a recovery to be anything but anaemic, and combined with a dreadful fiscal position it creates a strong likelihood of low interest rates.

Rising oil prices and a weak pound will push up the headline inflation rate. But, the Bank needs to learn from its mistake of early 2008 - paying too much attention to temporary oil price induced inflation. Apart from these temporary factors, underlying inflationary pressures will remain muted. They will remain muted because unemployment will remain high and there is considerable spare capacity in the economy. Whilst spare capacity exists and inflationary pressures remain muted, the Bank can keep interest rates low.

At the same time, there will need to be some tightening of fiscal policy (higher taxes) (e.g. VAT will go back up to 17.5% - reducing consumer spending).

These tax rises, could reduce spending and derail the recovery. This deflationary impact of higher taxes makes even less chance for interest rate increases in the near future. It is quite feasible that interest rates could remain at 0.5% for the duration of 2010.

As other countries start raising rates, Low UK interest rates could further weaken the Pound. But, I don't think the government / MPC will be concerned about that. A weaker pound will just be another tool in helping the economy to recover. They may not like to admit it, but the monetary authorities seem to have a policy of 'benign neglect' towards Pound Sterling.

During the recovery, any inflationary pressures would justify a tightening of fiscal policy before monetary policy. Government borrowing is uncomfortably high. Government borrowing needs tackling in a way that doesn't create a second downturn. It makes a convincing case for loose monetary policy (0% interest rates, quantitative easing) and tightening of fiscal policy when the economy is able to absorb it.

The other factor is that the economic crisis has arguably changed consumer attitudes, the economy has gone from an economy of borrowers to an economy of savers. Another reason why inflationary pressures will remain muted and interest rates low.

At least some will benefit from the current economic situation. Now, if only I had bought a tracker mortgage in 2007....

The UK budget deficit is predicted to rise from 40% of GDP last year, to 100% of GDP by 2014.
Japan by comparison already has a budget deficit of 218% this year and a predicted deficit of 246% by 2014.
Japan has a real problem in the unprecedented scale of its fiscal deficit. It also has a real problem with deflation. Japanese consumer prices fell 2.4% in September, the largest on record.
Exports have fallen 31% after the great recession and a rapid appreciation of the Yen.
Demographics are working against Japan. The workforce is contracting due to low population growth and an ageing population. The Japanese economy has stagnated (grown below potential) ever since its 1980s bubble burst.

The economic situation is dire. The immediate policy response should be to end deflation. Japan desperately needs a positive rate of inflation. This will help prevent real debt burden rising. Inflation will reduce the value of the Yen, making exports more competitive.

Combined with a loosening of monetary policy, Japan will be able to start tackling its budget deficit. Yet, the Bank of Japan has already indicated that it will end its limited policy of quantitative easing meaning there are no real policies to deal with the deflationary pressures. It seems Japan doesn't have the political will to deal with the problems it faces; it is almost as if it is waiting for a real crisis. (Perhaps when markets start to worry over extent of Japanese debt)

Why has Huge Budget Deficits failed to boost Growth in Japan?

Increasing government debt, during a period of deflation does not really help. Budget deficits can provide a boost to aggregate demand, if combined with positive money supply growth.
Also, budget deficits need to be a temporary affair, not a permanent two decade fiscal expansion. The deficit also reflects the structural weaknesses of the economy - pension requirements growing in an ageing population.

Lessons for UK and US.

The lessons for the UK and US from Japan are:

• Avoid Deflation at all Costs. Don't implement timid policies claiming you are frightened at the prospect of inflation.
• Avoid Government debt rising for two decades.
• If necessary monetary policy will have to take slack from fiscal tightening, when the time is right.
• Avoid having a very strong currency when your economy is in recession and exporters are suffering.
• Make sure the economy remains dynamic and productive through incentives to be more efficient.
  

Related

• National Debt in Japan
• Japan Saving Ratio
• Deflation in Japan
• It is Japan we should be worrying about Ambrose Evans-Pritchard in Telegraph

It's been a bad 12 months for the UK economy. 2010, should see some kind of economic recovery. But, few are expecting a rapid rebound. These are some of the problems facing the UK economy, into 2010.

Depth of the Recession.

Typically, the UK economy expands at an average underlying trend rate of about 2.5%. Even zero growth will lead to a growth in spare capacity and unemployment. After 6 consecutive quarters of falling GDP, the output gap is significant. This means output is significantly below potential, firms will be reluctant to hire. There is a danger that the recession will lead to a permanent loss of output and jobs and shrink the UK's productive capacity .

Unemployment.

The Bank has an inflation target of 2%, but it is unemployment which creates the most social / personal misery. So far, the rise in unemployment has been relatively muted, at least, given the scale of recession. However, this slow rise in unemployment means it will be slower to fall. After the 1992 recession, unemployment fell relatively quickly, but after this recession, the fall in unemployment is likely to be slower - more like the experience of the 1980s where unemployment remained close to 3 million for several years. In particular, it is young workers who have been hardest hit. The fear is that prolonged youth unemployment could lead to a return to the unemployment related social unrest, characteristic of the early 1980s.

Budget Deficit.

In the past few years, the UK's public finances have taken a real battering, leading to record peace time deficits. We relied on bubble taxes (property taxes, income tax on bonuses e.t.c) to help fuel inflation beating rises in government spending. Yet, these tax sources have dried up leading to a budget deficit approaching £200bn.

The dilemma is that, although the budget deficit continues to rise towards 100% of GDP, reducing the deficit too early could push the economy back into recession. For example, if the Conservatives were to implement their plans for spending cuts next year, the deflationary effect could well push a fragile economy back into recession.

Problems of Prolonged Borrowing

Economic necessity will make it difficult to tackle the budget deficit. But, this means the budget deficit will continue to grow and this brings future problems. If debt grows too quickly towards 100% of GDP, it may effect the UK's credit rating. This would make it more expensive to borrow and pay the debt interest payments.

In the longer term, there is a also a fear relating to the size of the debt and quantitative easing. Increasing the money supply, rises the prospect of future inflation and a weaker sterling. At the moment, there is little real fear of inflation and a weak pound is helping the economy to recover. But, there is a danger continued high levels of borrowing could weaken pound and could create future inflation.

Trade Deficit / Unbalanced Economy

The UK has been running a current account deficit, more or less since the recession of 1981. The economy has relied on services and the financial sector. We have struggled to remain competitive in the manufacturing / industrial sector leading to a trade deficit. Often the problems of trade deficits / decline in manufacturing are exaggerated, but the UK economy does still feel unbalanced and this is one reason why the UK economy was hit by the recession much more than other countries.

Propensity to Boom and Bust

I have written about the problems of UK housing market in more detail here. Yet, the continued shortage of supply means the UK will be sensitive to future booms and busts. It is hard to believe house prices have risen so much in the middle of a recession - a sign of the fundamental imbalances which exist in the housing market.

Weak Sterling

At the moment, I don't see the weak sterling as an economic problem. The depreciation has helped to limit the fall in economic growth and, over time, will help to rebalance the economy and reduce trade deficit. But, if sterling continues to be weak over the longer term, there could be inflationary risks and a decline in living standards as imports become more expensive.

Demographic Changes - An ageing population and unfunded pension deficits, will make the governments public finances more difficult in the future.

These problems, could equally be applied to the US economy. I think one important issue is to be clear on which problem is the most serious. For example, government borrowing is a definite problem. But, although it is very serious, it is more important to worry about the loss of output and unemployment first.

Related

• Problems of credit crunch
• Problems of Recessions