Is the younger generation worse off than their parents?

Readers Questions: is this the worse time to be a young adult in the UK?

I will answer this question primarily from the economic point of view.

The first thought that springs to mind is that if you look at the long history of the UK, this is probably a good time to be young in the UK.

real-gdp-growth-55-14

Median incomes are close to an all time high (even despite the fall since since the 2008 crisis), educational opportunities are arguably better than before (even if more expensive), unemployment is relatively low and likely to fall (even if there is greater insecurity in the new job market).

It is always tempting to think that every thing was rosy in the past. But, living standards have consistently risen in the past few decades. It is true, that for the past five years, real incomes have stagnated even fallen, throwing into greater contrast rising living costs, especially housing. However, were the previous generation really better off?

Economic problems facing young people

There are several reasons to be concerned about prospects for young people.

Firstly, housing is a real problem. There is a serious shortage of affordable housing – especially in London and the south. This means that many young people simply can’t afford to buy a house like their parents generation could. Home ownership rates are falling – especially amongst people under 30.

house-price-income

House prices are rising faster than incomes. See more at UK housing market stats – including house price to income ratios. For many young people, buying a house is just an impossibility.

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UK Inflation Rate and Graphs

Current UK Inflation Rate

  • CPI inflation rate: 1.3% (headline rate)
  • CPIH – 1.3% in the year to Aug 2014
  •  (page updated 18 November, 2014)

monthly-inflation

 

CPI and CPIH

CPIH is a new experimental index from the ONS. It is based on CPI, plus it includes housing costs, such as mortgage interest payments. Owner occupiers cost (OOH) account for 12% of the CPIH weighting. Mortgage interest payments are the biggest part of OOH. Mortgage interest payments average 10% of household expenditure.

cpi-cpih-inflation

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Japanese National Debt

Readers Question: How is Japan able to run a national debt of nearly 240% of GDP? (from: List of National debt by Country)

In 2013, Japanese public sector debt rose to one quadrillion yen ($10.28 trillion). In 2013, this was 227% of GDP. This is significantly more than several European countries like Greece (150% of GDP, Italy 112% of GDP, UK 77% of GDP).

In the most recent budget deficit, Japanese government borrowing accounted for 7% of GDP.

Source: Hoshi and Ito (2012).

Despite the record debt levels, bond yields on Japanese debt are very low. Why is Japan able to borrow so much? Why have interest rates on Japanese bonds fallen?

Why Japan is able to borrow?

 

Why Japan is not Greece

Why Japan is not Greece: Source Beacon Reports on Japan

Current account surplus. Japan is running a current account surplus – attracting capital inflows into Japan; these  can be used by the private sector to buy government bonds. Japan doesn’t rely on external financing of its public sector debt. A high percentage of Japanese public sector debt is held domestically. 70% is held by the Bank of Japan, most of the rest is held by Japanese trust and investment funds. Despite a temporary inflow after the Euro debt crisis, foreign sector holdings of of medium- and long-term Japanese government securities remained below 7%. (Vox).

By contrast European periphery countries like Spain, Greece and Italy were also running current account deficits and had a greater reliance on external financing of domestic debt.

The Japanese private sector (both household and corporate) have a large appetite for buying government bonds. This is because domestic savings are relatively high. People and firms have spare cash to buy bonds and lend the government money. In a country with a very low saving rate, there would be less people willing / able to buy government debt. One concern that Japan has is that the domestic savings ratio is expected to continue to fall due to demographic changes. (See: Japan savings ratio)

Cost of debt servicing. Interest rates and bond yields in Japan are very low. (10 year bond yield is 0.5%) Therefore, the interest payments on the debt are relatively low. If interest rates in Japan were to rise, the cost of servicing the national debt would be much higher. Still debt interest payments account for a substantial amount of government spending. (15% of GDP, according to World Bank)

Japan has very low inflation and interest rates. The Bank of Japan is able to monetise part of the debt without causing inflation because of the depressed state of the economy. 70% of government debt is held by the Bank of Japan, which in theory doesn’t need repaying in the same way as to domestic savers. Adjusting for effects of tax, the nationwide core consumer-price index rose 1.0% in September, 2014 (WSJ). Analysts fear inflation could fall to 0.5% in 2015. A higher inflation rate would help the Japanese economic recovery.

Japan is still vulnerable – if the current account surplus falls, the external surplus will diminish reducing domestic purchase of government bonds.

If interest rates rise, the cost of financing the deficit will rise – though if interest rates do rise, this will hopefully be a reflection of an improving economic cycle, leading to higher growth.

In recent years, the Japanese government has been caught between trying to increase tax rates and increase the rate of economic growth. Unfortunately, they conflict. But, if Japan is to see a fall in debt to GDP ratio, then strong economic growth is a necessity.

 

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The failure of quantitative easing?

Readers Question. Just saw a video called ‘How to waste £375 billion? (The Failure of Quantitative Easing)’ by Positive Money. I’ve recently started reading your blog and find your posts very informative. I wonder what you make of the ideas in this video and of this group in particular?

(I haven’t seen the video. For some reason I never like watching videos only reading articles.)

I would say Quantitative easing has been a quantified success. Or perhaps a better way of evaluating quantitative easing is that – it could have been worse, if we hadn’t pursued quantitative easing.

A simple comparison is to compare the UK and US (who have both pursued quantitative easing) with the Eurozone (which hasn’t). In the past couple of years, the economic recovery has been stronger in the US and UK, the Eurozone is in danger of a double dip (or triple dip) recession. The Eurozone is heading towards a dangerous period of deflation. The UK and US have at least a better inflation rate.

Eurozone inflation

eurozone inflation

Therefore, I wouldn’t say we wasted £375 billion. Firstly, ‘wasting’ implies an opportunity cost – for example, finding it from higher taxes or lower spending. It was entirely created. For all its faults and limitations, the quantitative easing we pursued was better than nothing – especially given the degree of fiscal tightening pursued since 2010.

Problems with UK Quantitative easing

Perhaps a better description of UK quantitative easing is a wasted opportunity. True, we avoided some deflationary effects, but there are reasons to be disappointed and perhaps it could have been better.

Banks largely used the newly created money to make a profit from selling bonds to the Bank of England and improve their balance sheets; because of the recession, little of this extra money fed through into the real economy through higher bank lending (see: M4 lending stats). The side effect was some banks and the bond market did very and interest rates are at very low rates. True, low rates are part of the aim behind Quantitative easing, but low interest rates are of limited benefit, if firms are unable / unwilling to borrow and make use of cheap borrowing.

Parts of the financial services industry has benefited very well from quantitative easing. It is perhaps a little galling to see many of those culpable for aspects of the credit crisis gaining bonuses from the benefits of quantitative easing.

However, to say it solely benefited the rich is to ignore the contribution it may have made to reducing unemployment. UK unemployment has fallen for many reasons – the small economic stimulus is an important factor – never forget reducing unemployment is one of the most important factor in reducing relative poverty. The UK unemployment rate is now 50% lower than many areas in the Eurozone.

Who benefited from quantitative easing?

Printing money to fund government deficit

Would a better form of quantitative easing have been to print a smaller amount of money, but directly use this to finance government budget deficit, and / or fund public sector investment?

Some argue this would have directly led to higher demand and a stronger economy.

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Dutch disease

The Dutch disease refers to the problems associated with a rapid increase in the production of raw materials causing a decline in other sectors of the economy. When the raw materials run out, the economy can be in a worse position than before.

oil-field

oil field in Azerbaijan by Ken Douglas

– Can discovery of substantial raw materials be a curse in disguise?

If a country discovers substantial amounts of oil, gas or other natural commodity, it will begin to export these goods causing a substantial increase in GDP; this will improve tax revenues, improve the current account and create employment opportunities. But, often countries who discovered oil have gained much less than you might expect.

These are the likely economic effects of discovery oil / gas.

1. Appreciation in currency. Due to the discovery of oil and increase in exports, the country will see an appreciation in the exchange rate. This is because higher demand for exports lead to increased demand for Sterling. For example, in the late 1970s, the UK saw a rapid appreciation in Sterling after the discovery of North Sea oil.

2. Decline in competitiveness. The problem of this appreciation in the exchange rate is that other trade-able sectors of the economy will become uncompetitive. Manufacturing industries will see a substantial fall in demand, due to the higher exchange rate. Therefore, the economy will shift from manufacturing towards the primary sector. In the early 1980s, UK manufacturing output fell significantly as a result of the appreciation in the Pound.

3. Growth in luxury imports. Higher output of oil will enable those who benefit to spend on luxury goods and luxury services. These luxury goods tend to be imported meaning that domestic firms gain little benefit.

4. Growth in real wages. Due to the increased wealth and spending on services, there will be higher demand for service sector workers (waiters, hairdressers, chauffeurs e.t.c). This will cause rising real wages in the economy, causing another problem for manufacturing firms as they have to increase real wages to retain workers. This will further decrease competitiveness of manufacturing exports.

5. Indirect-deindustrialisation. With manufacturing becoming uncompetitive due to higher exchange rate and higher wages, output will fall, and there will be a decline in investment, leading to lower growth. These sectors will begin to lag behind other countries. It can be very difficult to catch up later.

5. Income inequality. Often the discovery of raw materials, such as oil benefits a relatively small percentage of the population. Those who own the oil fields can see huge wealth, but the benefits of oil and gas are often not equally distributed within society. Workers may benefit from rising real wages in the service sector, but the discovery of raw materials often creates a few billionaires, so the increase in GDP is often concentrated in the hands of a small number. In several developing economies, oil fields are developed by foreign multinationals, causing some of the wealth to be taken away from the country. Continue Reading →

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The battle for market share in UK supermarkets

The UK grocery market has become increasingly competitive in the past few years. It is a good example of an oligopoly becoming more competitive. Certainly the growing strength of discount giants like Aldi and Lidl have really shaken up the market and diluted the cosy oligopoly previous enjoyed by the likes of Tesco and Sainsbury. To further add interest, Pound shops are also gaining market share and nibbling away at the margins of the big supermarkets. For consumers it is largely good news with lower prices, lower profit margins and a raft of incentives from supermarkets trying to hold onto market share.

Supermarket share 2014

uk-supermarket-share

 

The big three – in particular, Tesco and Sainsburys are suddenly having to pull a halt to ambitious expansion plans and in Tesco’s case have been left red faced by profits falling short of profit forecasts.

Why are Supermarkets becoming more competitive?

The supermarket industry is fairly contestable. There are few limits to opening a new superstore. Also, the shift to smaller, local convenience stores has made it even easier to set up new local supermarkets – rather than big, out of town supermarkets.

It is true there are significant economies of scale in purchasing, distribution and marketing, but even a relatively small supermarket chain like Lidl / Aldi seem to be able to exploit great economies of scale from their relatively small market share. It is not like the car industry where the minimum efficient scale is a much bigger share of the market.

In the case of Lidl and Aldi, it is very successful European supermarkets bringing their model to the UK. They both have a strong track record of taking on bigger, higher margin supermarkets and attracting customers from a wide range of social backgrounds – attracted by very low cost goods. In 2014, Aldi has achieved its highest ever growth of 35.3%, increasing its market share to 4.6%. It is planning to open another 60 stores in 2015

supermarket-growth

Falling real incomes

The past few years have been particularly tough for the hard pressed British consumer. In the past few years, inflation has consistently been higher than nominal wage growth - causing the most persistent fall in real incomes since before the war. In such straightened times, it is unsurprising that consumers have become more sensitive to price, seeking out bargains in Pound shops and budget, no-nonsense supermarkets like Lidl. The great recession, is not a good time for supermarkets like Sainsbury and Tesco who have relied on a higher price markup. Continue Reading →

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The limitation of economic data

Readers Comment from UK debt under Labour. In 13 years from 1997/8 to 2009/10, the Labour Government increased debt by about £420 billion. In the 5 years from 2010/11 to 2014/2015, the Coalition Government will increase debt by about £600 billion. These are the facts.

 

public-sector-debt-ons

Yes, though I’m always nervous about extracting facts like this.

It is true that under the Coalition government of 2010 onwards public sector debt has increased significantly. Debt to GDP has increased at a rapid rate. But, that doesn’t mean it is a reason to blame the coalition government for rising debt. Rising public sector debt was both inevitable and desirable given the poor global economic performance,  shrinking tax base and expansionary fiscal policy of the previous government.

I would argue, that 2010-2014 – it’s a shame government borrowing didn’t increase a little more. In a recession, with a fall in private sector spending, and rapid rise in private sector saving – you want to see an increase in government borrowing to help maintain overall demand, especially with Q.E, low inflation and low interest rates,.

Comparing debt levels from 1997 to 2010 and comparing debt levels during the great recession is a very difficult comparison. The economic situation is so different, that the required response needed is also very different.

However, the point about UK debt under Labour. was to make the point that (contrary to many people’s opinion) UK government borrowing had fallen to a near record post-war low in the run up to the credit crunch. Excessive government borrowing was definitely not a cause of the crisis of 2008 onwards.

 

Economic growth

Another thing that can make me suspicious is when people point to very recent quarterly economic growth figures and claim that as vindication or otherwise of a particular economic policy.

economic-growth-quarterly

UK growth – good record in past six quarters

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Tight monetary policy in the EU

Tight monetary policy implies the Central Bank is trying to reduce the demand for money and limit the pace of economic expansion.

A tightening of monetary policy, could involve an increase in interest rates. – Higher interest rates increase the cost of borrowing and discourage investment and consumer spending. A tightening of monetary policy would be appropriate in a period of positive economic growth and rising inflation, above the inflation target.

Europe has neither. The Eurozone is facing an inflation rate of 0.4% and weak economic growth. However, monetary policy has been relatively tight.

Two graphs from Antonio Fatas help to illustrate this.

Real interest rates in US and EU

Latest-real-interest-rates

Source: Helicopter money A.Fatas

Real interest rates are the nominal interest rate – inflation rate.

Therefore, with base rates of 0.5% and inflation of 4%, the US would have a real interest rate of -3.5% – This negative interest rates, in theory, should be more encouraging for people to spend rather than save.

By contrast, the ECB have had higher real interest rates. This is partly because they increased nominal interest rates in 2013, but mainly because European inflation has been lower. The decline in Eurozone inflation to 0.4% has had the effect of increasing real interest rates.

UK real interest rates have been similar to the US. UK inflation has been higher than Eurozone inflation.

The increase in real interest rates in Europe are a serious cause for concern and a good illustration of one of the problems of deflation / low inflation.

With deflation, monetary policy can become unsuitable. Because you can’t cut base rates below zero, monetary policy can become tighter than market conditions allow.

Unfortunately the higher real interest rates and the tightening of monetary policy makes deflation more likely. It is a vicious circle.

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Unemployment during economic boom

Q2: Why are there millions of people unemployed even when the economy is booming?

During periods of strong economic growth, we can often experience high rates of unemployment. Firstly, there may be structural unemployment. This occurs when the unemployed are unsuited or unable to fill job vacancies. For example, a booming economy may have a growing number of jobs in high-tech industries, but many unemployed may not have the right skills for this job.

Alternatively, we could see geographical unemployment. This occurs when the economy is booming in the south, but unemployed workers in the north are unable or unwilling to move to the south (for example, difficulty of getting housing in London, where jobs are available.

Inflexible labour markets. Another potential problem is that labour markets may be inflexible. For example, high minimum wages or costly regulations may discourage firms from employing people, despite high growth.

Frictional unemployment. In a modern economy we usually see some inevitable frictional unemployment – when people are in between jobs and taking time to find the job best suited to their skills. Therefore, in practise, full employment is never 0% – we can always expect around 2-3% unemployment due to this frictional unemployment. – Temporary short term unemployment

Another potential issue is that some types of economic growth could involve less employment opportunities. For example, the software industry may be able to add high value added to GDP, without employing a large quantity of workers. Labour intensive industries on the other hand may be closing down and these unskilled manual workers find it difficult to move into other areas. There have been some concerns that recent global economic growth has been in industries with lower job creation than usual.

Good example of high unemployment in an economic boom

unemployment-percent-79-present

If we look at the UK economy in the 1980s, there is persistently high unemployment, despite strong economic growth in the mid and late 1980s. Unemployment was slow to fall, and even at the peak of the economic boom, unemployment was still over 1.6 million. One reason for this is that in the 1980s the UK economy went through a radical restructuring. Manufacturing output fell significantly, causing a big loss of jobs in the north and amongst unskilled manual workers. New jobs were created in the south and service sector, but there was a lag in these unemployed workers finding new employment.

economic-growth-unemployment

In the current economic recovery, UK unemployment has fallen much faster. Despite weak growth since 2010, UK unemployment has fallen by more than many economists expected, suggesting labour markets are becoming more flexible. It has also helped that wage growth has been very muted, encouraging firms to hire more workers.

UK unemployment-rate
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Why does the cost of living keep rising?

Readers Question: Why does the cost of living keep rising?

This is due to inflation – the persistent increase in the average price level. In modern economies, inflation is a common feature. In fact most Central Banks target a low rate of inflation of 2%.

Central banks feel that a moderate rate of inflation is consistent with a steady rate of economic growth.

For various reasons a zero inflation rate could create problems – especially, if people are used to moderate inflation. See: costs of low inflation and deflation.

The important thing is – are incomes rising faster than prices and the cost of living? If your cost of living rises at 2%, but average incomes are rising at 5% a year, then you’re real income is increasing by 3% – you are better off, despite the increased cost of living.

However, if prices are rising, and your income staying the same, then your real income is falling – you are effectively worse off because you cannot afford to buy as many goods.

Prices don’t always rise

inflation-1910-2010

Note. prices don’t always rise. In the 1920s and 1930s, the UK had a period of deflation – falling prices and the cost of living was going down. However, this wasn’t a good situation because it was also a period of high unemployment and low growth. Japan has experienced deflation in recent decades, and the EU is getting close to zero inflation

 

Why is inflation considered normal in modern economies?

I’m not exactly sure, but somehow economic growth tends to cause some moderate price rises. Also, a low inflation of 2%, makes it easier for relative prices to adjust. With inflation of 2% – some prices like services may rise by 4%, some prices like mobile phones may stay at 0%. Some goods like food may rise by 2%.

Because there is downward price and wage rigidity, it is easier to have these price adjustments with low inflation than zero inflation.

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