The relationship between economics and politics

Readers question: Why cannot politics and economics be seen in isolation?

Economics is concerned with studying and influencing the economy. Politics is the theory and practice of influencing people through the exercise of power, e.g. governments, elections and political parties.

In theory, economics could be non-political. An ideal economist should ignore any political bias or prejudice to give neutral unbiased information and recommendations on how to improve the economic performance of a country. Elected politicians could then weigh up this economic information and decide.


In practise there is a strong relationship between economics and politics because the performance of the economy is one of the key political battlegrounds. Many economic issues are inherently political because they lend themselves to different opinions.

Political ideology influencing economic thought

Many economic issues are seen through the eyes of political beliefs. For example, some people are instinctively  more suspicious of government intervention. Therefore, they prefer economic policies which seek to reduce government interference in the economy. For example, – supply side economics, which concentrates on deregulation, privatisation and tax cuts.

On the other hand, economists may have a preference for promoting greater equality in society and be more willing to encourage government intervention to pursue that end.

If you set different economists to report on the desirability of income tax cuts for the rich, their policy proposals are likely to reflect their political preferences. You can always find some evidence to support the benefits of tax cuts, you can always find some evidence to support the benefits of higher tax.

Some economists may be scrupulously neutral and not have any political leanings (though I haven’t met too many). They may produce a paper that perhaps challenges their previous views. Despite their preferences, they may find there is no case for rail privatisation or perhaps they find tax cuts do actually increase economic welfare.

However, for a politician, they can use those economists and economic research which backs their political view. Mrs Thatcher and Ronald Reagan were great champions of supply side economists like Milton Friedman, Keith Joseph, and  Friedrich Hayek. When Reagan was attempting to ‘roll back the frontiers of the state’ – there were no shortage of economists who were able to provide a theoretical justification for the political experiment. There were just as many economists suggesting this was not a good idea, but economists can be promoted by their political sponsors. In the US, the Paul Ryan budget proposals were welcomed by many Republicans because they promised tax cuts for better off, cutting welfare benefits and balancing the budget. (1) A popular selection of policies for Republicans.

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UK National Debt

The UK national debt is the total amount of money the British government owes to the private sector and other purchasers of UK gilts.

  • At the end of June 2014, public sector net debt (excluding financial interventions (PSND ex) was £1,304.6 billion, equivalent to 77.3% of gross domestic product.
  • Source: ONS [1. ONS public sector finances ] [This figure excludes temporary effects of financial interventions (PSND ex) (page updated Aug 12th 2014)


Annual Borrowing

  • For the financial year 2013/14, Public Sector Net Borrowing PSNB ex was £93.7 billion  – (5.6% of GDP)
  • The central government net cash requirement (CGNCR) for the financial year 2013/14 was £75.4 billion, £29.6 billion lower than the same period in 2012/13 (£105.0 billion). This figure is lower than PSNB ex because it includes one off receipts, e.g. Royal Mail transfer.


Office for Budget Responsibility

As well as ONS, the Office for Budget Responsibility is a good source for data.

Latest statistics at OBR

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The economics of Hollywood

Readers question: Why does Hollywood make so many superheroes movies nowadays? What can be the economics behind it?

I’m not really a movie goer. I think the last Superhero move I watched was the original Superman back in the days when Coal miners were still a political force and people used to rent videos to watch in VHS tape players.

One reason I don’t like the usual Hollywood movies is that they are so predictable, and frankly you can get soon bored of the same formula – good guy goes down on his luck, but when things look really bleak – Superman comes back from the brink, defeats the bad guy and everyone lives happily ever after.

So, if they are so depressingly predictable, why do so many super-hero style movies get made by Hollywood?


Risk vs solid reward

Making movies is a risky business. But, ultimately studios are interested in making a profit – not in producing artistic films which may appeal to hard bitten film critics. You have to put a lot of money in, and you need to guarantee that you get a good return. With superhero style movies, they have a strong track record of getting decent revenues. If Superman 1,2,3, and 4 all made a profit. Then you could make an approximation that Superman 5 has a good chance of making profit too.

Suppose some new film director came along with a risky plot – something very independent, different, ‘artistic’ and challenging. – It could be a great success, but equally it could be a flop. You could make slightly higher than usual profits, but equally you could make a loss. Given the choice between a risky new style film and a guaranteed ‘banker’ – there is a strong economic incentive for you to choose the ‘safe’ option of another superman hero movie.

A good example, is the TV series ‘Breaking bad’ – It is critically acclaimed as one of the most innovative and well produced TV series of all times. But, when the creator approached TV networks, no one wanted to touch it. TV producers couldn’t see any track record for successful  / profitable TV based on a chemistry teacher cooking crystal meth. It was very successful in the end, but the success was unexpected. Generally, TV producers would rather commission something with a more certain audience (like minor celebrities eating worms in the jungle)

Advertising and brand loyalty

One difficulty with producing films is that you have to gain strong brand loyalty in a short space of time.  If nobody has heard about the subject of the film, it will be harder to attract interest. The advantage of producing a superhero movie is that there is an instant brand loyalty and awareness of the superhero like Spiderman / Superman. By using well known comic characters, you have effectively got a lot of free advertising – from the long period of customer awareness of the superhero.

The most successful film franchise – James Bond has a huge advantage because the brand of the film series is so well known. You know a James Bond film may be quite predictable, but at least you know you are going to see some good action shots, fast cars, beautiful women and spectacular backdrops.

It is one reason why books are often made into films. Awareness of the books, helps with the advertising for the film. Continue Reading →


Economic Goods – definition and examples

An economic good is a good or service that has a benefit (utility) to society. Also economic goods have a degree of scarcity and therefore an opportunity cost. This is in contrast to a free good (like air, sea water) where there is no opportunity cost – but abundance. Free goods cannot be traded because nobody living by the sea would buy seawater – there is no point.

However with economic goods where there is some scarcity and value, people will be willing to pay for them.

Another feature of an economic good is that if it can have a value placed on the good, it can be traded in the market place and valued using a form of money.

An economic good will have some degree of scarcity in relation to demand. It is the scarcity that creates a value people become willing to pay for. It is the scarcity which creates opportunity cost. – For example, if we pick apples from a tree, it means that other people will not be able to enjoy them. If we devote resources to mining gold, the opportunity cost is that we can’t devote this time and effort to growing corn.

Readers Question: Can endangered plant/animal species be economic goods? If so then why?


“Dead as a Dodo” But, was the Dodo an economic good?

Firstly, do endangered plants / animal species have a value to man?

  • Many endangered plants and species do have a benefit to humanity, even if we are not aware of them. For example, rare plants may hold the key to creating a vaccine for a disease. If we allow the plant to become extinct, then we lose this bio-diversity and future potential to treat human diseases. This is a clear example of how endangered plants could have a very high economic value.
  • It may be harder to make the case for endangered species. You could argue that some reptile on the verge of extinction has little or no value to humans, therefore some might not class it as an economic good.
  • However, others may disagree, they argue that when considering economic value, we shouldn’t just consider narrow human interest. We could argue that we should look at the issue from a less human-specific perspective. We should see all life as having an intrinsic value.
  • Furthermore, ecologists may argue that protecting the biodiversity of the planet should give joy to humans – we should get utility and satisfaction from being guardians of the planet rather than destroyers of life. Therefore protecting so called ‘useless’ species can actually give utility to humans because we can feel ‘good’ about being responsible citizens of the planet.
  • The difficulty is that a strict definition of an economic good says that the value of the good should have some market value and be traded. It is hard to put a value on the benefit of saving a rare species from extinction. But at least, some people, would spend money to save a species from extinction because they feel it is a worthwhile act. Therefore, the rare species do have an economic value.

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Economic reasons for long school vacations

Readers Questions: I want to know the economic reason behind:

Summer/Winter vacations in school?
or: Why we have summer/winter vacations in school.

This is an interesting question, especially as I have just finished teaching for the year and begun the long summer holidays myself.

Oxford students on their way to their last exam in May. Oxford only have 24 weeks of teaching per year.

Oxford students on their way to their last exam in May. Oxford only have 24 weeks of teaching per year.

Possible economic reasons

Non-monetary benefit for teachers. Generally, teachers pay is relatively low for the standard of their qualifications. Teachers with good degrees could probably choose a career with higher monetary benefits (and less stress) if they moved to the city or something like that. Most teachers are paid by the government, so pay is not dependent on market forces, but government’s tight budgets. Giving teachers a six week summer vacation could be seen as a non-monetary benefit to compensate for the relatively lower pay. I’ve heard some teachers say the long summer holidays are one of the best perks of the job. I’m sure if the summer holidays were just one week, there would be an even bigger rush to leave the profession, and the government would have to raise salaries to attract teachers. The government wouldn’t want to have to increase teachers pay, so it’s easier to leave the long holidays.

Education has little short term productivity. Education is not like a factory producing cars. A car factory couldn’t afford to have a six week summer break because output would immediately fall, and average costs rise (less output, less economies of scale). However, education is very different. If students take long holidays, there is going to be little change in long-term productivity of the economy. In the short term, there will be no change in the productivity of the economy. Education does not directly increase GDP. Therefore, long  school holidays do not directly reduce real output.

More productive use of time. You could argue that long summer holidays are a useful opportunity for students to work in temporary summer jobs – helping the tourism industry. Summer holidays also enable teachers to work marking examination papers (I did this for a few years before I could take it no longer)

Diminishing returns from teaching longer hours. If we switched from 6 week to 2 week summer holiday – would we really get a more productive and highly educated workforce? I doubt it. Students are hard to teach by the end of May, let alone trying to teach them into mid August. Teaching students for long hours has diminishing returns. Increase the number of school weeks by 10%, may only give a 1% increase in the standards of education.

Therefore, extending the school year would have little benefit to the economy in terms of improved education standards and higher productivity. Continue Reading →


Napoleon, eggs and capturing consumer surplus

On campaign in the early 1800s, Napoleon approached a hostelry on the slopes of  Col du Pin Bouchain near Roanne. (BTW: the Col du Pin Bouchain at 759m was the first mountain ever used in the Tour de France in the 1903 edition.)


Napoleon was shocked at the price of eggs, and so he asked the owners of the hostelry

“Are eggs so rare in this region that they justify such a bill?’

The owner of the hostelry replied.

“It’s not the eggs that are rare, it’s Emperors.”

Supply and Demand in action!

This is an example of a monopoly seller capturing the consumer surplus of Napoleon – assuming an Emperor would have deep pockets and would be willing to pay more money to get some eggs, rather than walk to the next village.

Just imagine if shop owners could always know the income of the consumer and how much they would be willing to pay. They could make up a price depending on the consumer.

The only thing is I don’t know how this story ended. Perhaps Napoleon said.

“Since there is only one Emperor, I’m going to make a new law that the Emperor is allowed to requisition all eggs to help fund his military campaigns.”

Still you’ve got to admire the guts of the hotel owner for trying to capture Napoleon’s consumer surplus.



Inflation: Advantages and disadvantages

Readers Question: what are the advantages and disadvantages of inflation?

Inflation occurs when there is a sustained increase in the general price level. Traditionally high inflation rates are considered to be damaging to an economy. High inflation creates uncertainty and can wipe away the value of savings. However, most Central Banks target an inflation rate of 2%, suggesting that low inflation can have various advantages to the economy. Some economists even argue we should target a higher inflation rate during periods of economic stagnation.


The Advantages of Inflation:

1. Deflation (a fall in prices – negative inflation) is very harmful. During a prolonged period of deflation and very low inflation, the Japanese economy has suffered lower growth because of deflationary pressures. When prices are falling people are reluctant to spend money because they are concerned that prices will be cheaper in the future, therefore, they keep delaying purchases. Also, deflation increases the real value of debt and reduces the disposable income of individuals who are struggling to pay off their debt. When people take on a debt like a mortgage, they generally expect an inflation rate of 2% to help erode the value of debt over time. If this inflation rate of 2% fails to materialise, their debt burden will be greater than expected. See more Costs of deflation

2. Moderate inflation enables adjustment of wages. It is argued a moderate rate of inflation makes it easier to adjust relative wages. For example, it may be difficult to cut nominal wages (workers resent and resist nominal wage cut). But, if average wages are rising due to moderate inflation, it is easier to increase the wages of productive workers wages; unproductive workers can have their wages frozen – which is effectively a real wage cut. If we had zero inflation, we could end up with more real wage unemployment, with firms unable to cut wages to attract workers.

3. Inflation enables adjustment of relative prices. Similar to the last point, moderate inflation makes it easier to adjust relative prices. This is particularly important for a single currency like the Eurozone. Southern European countries like Italy, Spain and Greece became uncompetitive, leading to large current account deficit. Because Spain and Greece cannot devalue in the Single Currency, they are having to cut relative prices to regain competitiveness. With very low inflation in Europe, this means they have to cut prices and cut wages which causes lower growth (due to effects of deflation). If the Eurozone had moderate inflation, it would be easier for southern Europe to adjust and regain competitive without resort to deflation.

4. Inflation can boost growth. At times of very low inflation the economy may be stuck in a recession. Arguably targeting a higher rate of inflation can enable a boost in economic growth. This view is controversial. Not all economists would support targeting a higher inflation rate. However, some would target higher inflation, if the economy was stuck in a prolonged recession. See: Optimal inflation rate

For example, the Eurozone has had a very low inflation rate in 2013-14, and this has corresponded to very weak economic growth and very high unemployment. If the ECB had been willing to target higher inflation, then we could have seen a rise in Eurozone GDP.


Disadvantages of Inflation

Inflation is usually considered to be a problem when the inflation rate rises above 2%. The higher the inflation, the more serious the problem  it is. In extreme circumstances hyper inflation can wipe away peoples savings and cause great instability, e.g. Germany 1920s, Hungary 1940s, Zimbabwe 200s. However, in a modern economy, this kind of hyper inflation is rare. Usually inflation is accompanied with higher interest rates so savers do not see their savings wiped away. However, inflation can still cause problems. Continue Reading →

Bond Spreads

Readers Question: How do bond spreads affect the value of the Dollar or Euro?

A bond yield refers to the interest payment that you receive from holding the bond yield. If the yield is 4%, you can expect £4 a year from a £100 bond.

A bond spread refers to the differences in bond yields. For example, it could mean the spread between different government 10 year bond yields. In the US bond yields may be 2%, whereas in the Eurozone, bond yields may be 4%.

There could be many different reasons for this bond spread (difference) But, if markets are concerned that one country is at risk of debt default or liquidity shortages, investors may be unwilling to hold those bonds and therefore bond yields go up to try and attract investors. (See inverse relationship between bond price and bond yield)

EU bond Yields

A time when Italian and Spanish bonds had a large bond spread over UK and German.

If investors are nervous about holding Eurozone bonds, due to fears of illiquidity, then international investors will be demanding less Euros – they would prefer to hold dollars and buy US bonds. Therefore, in this case, we would expect to see an appreciation in the US dollar and a fall in the Euro.

If you look at government bond yields (FT) – Greece has a high bond yield 6%. If Greece had its own currency, you would expect the Greek Drachma to fall.

Argentina has had periods of high bond yields because investors are nervous about holding Argentinian debt due to fears of a debt default. This corresponded with a fall in the Argentinian currency.

However, high bond yields are not necessarily a reflection that markets are nervous about the state of government finances. Bond yields can rise when markets are optimistic about future economic growth. See: Factors affecting bond yields

However, it is worth bearing in mind, many other factors determine exchange rates, apart from bond spreads, such as:

  • Higher interest rates can attract hot money flows. If people are confident of a country and they see high interest rates, they may move their currency to benefit from better interest rates.
  • Relative inflation rates. If inflation is relatively low in a country, then demand for the currency will be higher in the long-term as their goods will become more competitive.
  • See: Factors influencing exchange rate

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Discuss why firms grow in size

Most firms seek to become bigger – increasing sales and market share. Firms can grow through internal expansion, external growth (merger) or diversification into related industries. The motives for increasing in size can include:

  • Greater sales lead to greater profit, making the firm more attractive to shareholders
  • Successful, growing firms are likely to increase salaries / pay bonuses to managers.
  • Increasing output enables economies of scale, greater efficiency and lower average costs.
  • Increased prestige for managers seeing the firm become more influential and powerful.
  • Greater risk diversification, e.g. when growth comes from product diversification.
  • Growing in size enables growth in market share and monopoly power, enabling even greater profitability.
  • Owners having a passion for their product and wanting to see it do well.
  • Globalisation has enabled firms to sell product in global market.

Reasons for firms growing

Profit motive

The profit motive is probably the biggest motive why firms try to grow in size. It is the incentive of profit which encourages owners to take risks to set up the business in the first place. When a firm has shareholders, there is a greater incentive to try and make profit to be able to pay shareholders a divident. However, when a firm seeks to grow, there is no guarantee that it will be more profitable. To increase market share may require lower prices, which reduce profitability. If a firm seeks to grow in size by diversifying into related industries, it may lack the expertise to do well in these different industries, e.g if an old media firm like Time Warner buys a new internet firm like AOL, there is no guarantee that Time Warner can prosper in the internet industry.

Motivations of managers and workers

Managers and workers may prefer to work for a bigger firm. This is maybe in the hope of getting a better salary or it may just be the personal satisfaction of working for a successful firm. However, it depends on worker morale; it may be that many workers and managers have little desire to see the firm grow – growth may just increase their stress and responsibility. Therefore, rather than growing, firms may end up pursuing a type of ‘satisficing’ where they do enough to keep their owners happy, but then pursue other objectives.

Economies of scale

Economies of scale are a justification for many mergers, which lead to a big increase in the size of firms. For industries with high fixed costs, growing in size may be necessary to stay competitive in a global market. For example, the building of airlines has become highly concentrated due to the very large economies of scale in that industry. Other industries like the car industry have also become increasingly concentrated with a smaller number of large firms dominating the market. Globalisation has definitely increased the speed at which large multinational companies have grown due to their global presence.

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The great Europe debate

The rise of UKIP and Euro-scepticism in the UK inspired me to have another look at an old blog post – Benefits of the European Union.

I’ve spent the past four years criticising the economic policy of the EU, and more specifically the ECB. There are may good reasons to be dissappointed at the EU in recent years. But there is always a danger that people can lose any sense of perspective and see the EU only as an unmitigated bureaucratic disaster more reminiscent of the Soviet Union than a modern progressive block of countries, who have made substantial progress in the past couple of decades.

Researching the benefits of the European Union was a reminder to myself that despite all the problems of the EU, it is not quite as bad as some politicians would like to make out. If nothing else – there is nowhere else in the world I would rather live than within the EU, where there is the rule of law, respect for human rights and decent living standards.

The European Union can count many significant achievements of the past few decades.

  • Reduction of tariff and non-tariff barriers have led to increased trade and, despite problems of recent years, real prosperity for most of the population.
  • Promoting human rights and helping Europe to become continent of peace, rather than the near perpetual conflict which marred the first half of the Twentieth Century.
  • Harmonisation of rules and regulations has helped simplify trade and commerce, and enabled the free movement of people.

Yes, despite many impressive achievements, the EU do seem in danger of throwing away, or at least diminishing many of these hard won gains. I don’t see the problem as regulation on bendy bananas (which are usually false or exaggerated for effect by Daily Trash newspapers – who seem to latch onto anti-EU headline with a glee previously reserved for stories about Princess Diana). The real problem the EU faces is economic stagnation, mass unemployment and the alienation of a whole young generation.

What makes it doubly sad is that it didn’t have to be like this.

The biggest problem facing the EU is one of economic policy. The Single Currency was a bridge too far. The EU is simply  not an optimal currency area. The limitations of the Single Currency have been magnified by an attempt to deal with deflationary pressure through a combination of misplaced austerity and the dogma of suffering. What makes it worse is that countries who have suffered the most economically, have the feeling that their economic suffering has been imposed from the outside. And this just isn’t political rhetoric, that’s how a single monetary policy works. It’s the worst combination – economic stagnation caused by policies outside your country. With the toxic mix of unemployment and outside influence, it is hardly surprising that political extremism is on the rise.

EU unemployment

Source: ECB

The ECB may claim that in the coming months they may do more to combat the threat of deflation and low growth. Now the ECB is willing to effectively act as lender of resort, bond yields have fallen. The Euro may hold together. But, that doesn’t change the fact Europe has been failing for the past five years. The crisis was never about bond yields or EU debt. When bond yields on government debt rise to 12%, this doesn’t cause social alienation and a surge in political extremism. The social and political alienation is caused by mass unemployment and a sense of powerlessness.

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