Readers Question: How does Global Economy Depend on Stock Market?

The stock market is often a reflection of what is happening in the economy. The stock market does have an impact on the economy, but, it is only one of many factors.

If the economy goes into recession or if there is a period of financial uncertainty then stock markets will generally fall reflecting the negative economic news.

In turn a falling stock market can impact the economy.

• Falling share prices decreases the wealth of some consumers. This decrease in wealth may lead to fall in spending.
• Falling share prices make it more difficult for firms to raise money on the stock markets, limiting investment.
• In extreme cases, fall in share prices may be so severe they can negatively impact on confidence.

However, the effect is limited as most consumers don’t own shares or their consumption is not directly tied to share values.

The recent stock market crashes were caused by the lack of confidence in the economy and financial system. Rather than falling shares causing a fall in confidence.

Leading stock market indexes like the FTSE-100 and Dow Jones are important in the sense that it gives an indication of the health of the biggest economies. Rising shares are a good sign, falling shares a bad sign, but in the short term, alot of price movements can be due to speculation.

Related Topics on Stock Market

• What Happens when the Stock Market falls?
• How the Stock Market Effects the Economy
• Causes of Great Depression and the role of the Stock Market Crash
• Different Stock Market Indexes

Heroin is a classic example of a demerit good:

1. People ignore or underestimate the costs of consuming heroin. In other words people make bad choices about deciding to consume this very addictive good.
2. Heroin consumption also has negative externalities for the rest of society. Heroin addicts become less productive, often unable to hold down a job. Also, heroin addicts are more likely to engage in crime to feed their habit.

Most governments take the decision that since the drug is very harmful for individuals and society, they will ban it and make it illegal.

However, the war on heroin is like many other drugs, a losing battle with no end in sight.

The United Nations Office on drugs and Crime estimated that opium production jumped to 8,900 tonnes in 2007, up from around 4,500 tonnes in the previous decade.

Of this estimated 8,900 tonnes produced, seizures of heroin rose to only 65 tonnes. Or 7.5% of annual production.

One solution would be to redouble efforts to clamp down on supply. Yet, even if a doubling of money did actually double the amount seized, that still leaves an awful lot of heroin on the market.

The failure to stem the supply of heroin is indicated by the market price. Reaching a peak of $300 in 1992, the price has fallen to $131. This market price is only $60 above wholesale prices indicating health competition in the street sale of heroin.

If stopping the supply of heroin is a doomed to failure, does this mean we should consider decriminalisation? Decriminalisation may not be as crazy as it first appears. Decriminialising heroin would have the following advantages.

1. It would significantly harm the operations of organised crime and petty criminals. Decriminalising heroin would take many users away from crime.
2. By legalising the drug the government could tax it and collect revenue.
3. Government control could help reduce the spread of HIV and other infectious diseases.
4. The reliability of the heroin could be assured. Many heroin deaths occur due to bad grade heroin.

The problem remains would legalisation encourage more people to try it and have their lives ruined by becoming addicted?

It is possible legalising heroin may take away the ‘glamour’ of taking something illegal, but, it is more likely that easier access may encourage more to try.

On the other hand, legalisation could be on a very strict basis with users having to undergo stringent interviews and plans to take them off the drug.

One thing is for certain the great ‘war on drugs’ will never be able to stop the supply.

Related

• Legalistaion of Drugs
  

Readers Question: What is Sensex and impact on economy?

The Sensex is the leading measure for the Indian Stock Market. It is based on the 30 Largest trading companies on the Bombay Stock Exchange BSE (India’s primary financial market)

Like other indexes, the Sensex is recalculated at various times to change the 30 largest trading companies. It was started on 01 Jan 1986 and uses a base year of 1978-79 and a base value of 100.

Since it’s introduction in the mid 1980s it has achieved above inflationary increase, benefiting from India’s improved economic performance.

As of 2009, the Indian stock market has averaged a yearly increase of 18.6% per annum or 9% a year in real terms.

However, after its peak of 20,873 in Jan 2008, the index has been hit by the global credit crunch and economic slowdown, which saw the index fall to 12,000 by May 2009.

Outlook for Sensex and Indian Economy

The Indian economy appears to have weathered the global economic downturn better than many of the other developed countries. Economic growth has remained positive and India continues to achieve one of the highest growth rates in the world after China. There is still tremendous potential in the Indian economy; however, it is hard to know how much future expected growth is already priced into the Sensex.

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Readers Question: Why is Inflation negative when prices are rising?

Often people ask, how come the inflation rate is negative, when I notice prices rising? Firstly, if prices in the basket of goods used to measure inflation are rising, then by definition that is inflation.

Deflation means the cost of living is decreasing and the prices in the basket of goods are decreasing.

Inflation is calculated using a basket of goods (1,000 of the most common items). The price increase is then multiplied by their weighting (their relative importance as a % of consumer spending.)

However, different goods are often rising at different rates. For example, petrol, which has a relatively high weighting, has been quite volatile in recent months. The fall in inflation was partly due to falling oil prices. Now that oil prices are rising, this will have an upward pressure on inflation.

It may depend on the type of goods you are buying. For example, a pensioner may spend a high % of his income on heat, light, fuel and food. If these goods are rising faster than the official inflation rate, their personal inflation rate will be higher than the average inflation rate.

Sometimes, we need to exclude volatile items to get a better picture of the underlying inflation trends. This graph uses a median value of inflation. Median measure excludes the most volatile goods). This suggests inflation is higher than the official figure.

Another issue is that there are different measures of inflation. In the UK, RPI includes mortgage payments. CPI doesn’t include mortgage payments. When interest rates fall, there is a sharp drop in mortgage payments and RPI. But, lower rates doesn’t effect CPI.

This is why we have had negative RPI inflation rate, but positive CPI inflation rate

Current Inflation Rates in the UK

See: RPI, CPI Inflation in the UK

Price of Gold

The global recession has seen good news for those investing in gold.

Gold makes a good investment during times of economic uncertainty. Gold has become more attractive because

Weakness of US Dollar. Growing budget deficits, deep recession and bank bailouts have all made the dollar less attractive. Signs that the Chinese are seeking to diversify away from the dollar are a signal of the changing fortunes of the global reserve currency.

The policy of quantitative easing has helped cause the threat of inflationary pressures in the economy. This uncertainty and fear of potential inflation has made gold look more attractive.

In a recession demand for gold falls, e.g. demand from India has moderated. But, this fall in demand has so far been outweighed by the financial insecurity and demand for alternatives to more common types of investment.

See: Investing in Gold during a recession

Low Interest Rates

This graph shows how far interest rates have fallen since Jan 1990 when interest rates peaked at 15%.

One issue is that many banks have not passed the 0.5% base rates onto consumers. In fact banks have already started increasing the rate on fixed mortgages.

UK Interest Rates

However, with low interest rates it does effect many consumers

• Mortgage payments are relatively cheaper
• Saving is less attractive; those relying on saving incomes have been hit hard by the low rates.

However, the effect of low interest rates depends on

1. Inflation rates. If inflation is higher than interest rates, then the real interest rate is negative and so savers are definitely becoming worse off.
2. How long will interest rates stay low? This is the big question. Will inflationary pressure return causing rates to rise sharply. When firms are making decisions about investing, an important factor is certainty over future rates. Low interest rates may not encourage investment if there is uncertainty about the extent of future interest rate rises.
3. UK rates compared to Euro and US rates. If Euro rates and US fall to the same level as UK rates, the impact on Sterling will be muted. But, if Euro rates were much higher than UK rates then the Euro would remain relatively strong. However, signs are that Euro rates will not be rising anytime soon.

Saving Rates in UK

A Classic example of the paradox of thrift. Since the start of the recession, household saving rates have increased sharply. From a negative saving rate, consumers have become more risk averse and sought to increase their savings. This rise in private sector saving has been offset by a rise in government borrowing.

The increase in saving rates may also be due to the difficulty of getting loans which are forcing consumers to save rather than borrow.

Also since the banks are facing a shortfall of liquidity after their losses, they are still keen to attract savings rather than lend. This graph shows the increased gap between mortgage rates and time deposit saving rates.

Saving and Bank Borrowing Rates

Saving and Mortgage Rates

• See also: Principles of Borrowing
• Economics of saving
• Saving Ratio in UK

In the UK, we have a marginal tax rate system. This means income tax is charged on income above a certain level. It does not mean if you earn £200,000 you pay 50% on the whole £200,000. You only pay 50% on the income earned above £150,000 after the personal allowance is included

Income Tax Rates 2009-10

• Personal tax allowance - £6,475
• Basic Rate - 20% - £0-£37,400
• Higher Rate - 40% - Over £37,400 - £150,000
• 50% Top Rate - 50% Over £150,000

Examples of Income Tax.

If you earn £7,000 in a year. The first £6,475 is tax free. Therefore, you pay tax on the last £525. Therefore, the income tax payable on £7,000 is £105. effectively you pay an average income tax of 1.5%.

If you earn £30,000. Your income tax will be 20% of £23,525 = £4,705 or an average tax rate of 15%.

If you earn £50,000. Your income tax will be:

• 0 - 6,475 @ 0% = £0
• 6,475 - 37,400 @ 20% = £6,185
• 37,400 - 50,000 @ 40% = £5,040

Total income tax = £11,225 or 22.5% average tax rate.

more on income tax rates

A list of the major banks and their subsidiaries

Other Banks owned by Foreign Firms

• Yorkshire Bank - National Bank of Australia
• Egg finance. - Citigroup

Nationalised Banks in UK

• - Northern Rock nationalised in 2008
• - Mortgage arm of Bradford & Bingley. (savings branch sold to Santander)

Government Stakes in UK Banks

• Government owns 65% of Lloyds shares
• Government owns 70% of Royal Bank of Scotland
• At one time, Barclays looked like it needed government cash but so far has sought to raise money privately

List of banks in UK

Readers Question: why are measures to increase spending in a recession generally considered a good response and why extra spending is less inflationary in this situation.

There are quite a few reasons. But, a general principle is the importance of confidence (Keynes referred to ‘animal spirits’). In a recession, people become pessimistic and therefore very reluctant to spend and invest. If unchecked this negative confidence can cause a negative momentum effect in the economy.

One specific example is the paradox of thrift. Keynes noted that in the Great depression, individuals felt their best response was to save more. But, cumulatively, this  was harmful for the economy.

In a recession, people tend to increase their savings significantly. But, this sharp rise in savings causes a sharp drop in consumer spending. Therefore, the government need to moderate this rise in savings. A higher savings rate may be desirable in the long term. But, if the saving rate rises too quickly too much, it can cause a sharp drop in GDP. More on Paradox of Thrift.

Saving Rates UK - Source: H.M Treasury

This graph shows how sharply UK saving rates have increased since the start of the current difficulties. This rise in savings means a corresponding fall in spending.

This rise in spending doesn’t cause inflation because in a recession there is spare capacity.

See also:

• Rise in Government borrowing to offset fall in private sector borrowing
• An economic crisis averted? - How rapid intervention to prop up spending has perhaps averted a much sharper fall in spending.