November 19th, 2009 — economics
A reader was asking how the credit crunch may have been different if banks had correctly forecasted falls in house prices. To be sarcastic, we could say if the Captain of the Titanic had know he was going to hit an iceburg, he probably wouldn’t have sailed.
Certainly, if banks knew house prices were going to fall 20-25%, they would (presumably) never have lent the raft of unconventional mortgages which had little chance of repayment. (This was particularly a problem in the US)
The credit crunch was caused by many other factors, and not just a failure to predict house price falls. But, better forecasting or more realistic forecasting would definitely have helped minimise the problem.
Difficulty of Forecasting
It is very difficult to predict economic data such as house prices.
- At the end of the last crash in 1995, how many would have predicted a near tripling of house prices in the next decade?
- Some were predicting house price collapses in 2007. But, many of these commentators had started predicting house price falls as early as 2003.
- Not many predicted the rise in house prices we saw in 2009
But, it is important to retain a sense of perspective and try and avoid any irrational exuberance which can lead people to ignore possibilities such as house price falls. Predicting house price falls
I tend to be most sceptical of those forecasts which display a fundamentalist assurance of ‘collapse in prices’ or ‘hyperinflation’
Importance of Forecasts for Monetary Policy
Economic forecasts are very important for determining monetary policy / fiscal policy. If the economy is really expected to recover, then inflation may pick up and the Bank may need to raise interest rates. If the economy is likely to continue to shrink, the Bank may need to pursue further quantitative easing.
Another issue for the Bank of England is that interest rate changes can take up to 18 months to have an effect. Therefore when the Bank change interest rates, they are trying to set the optimal rates for the future economic situation. See: How Bank of England set interest rates
Importance of Exchange Rate Forecasts
For firms trading with other countries, movements in the exchange rate can be very important. A sharp appreciation in sterling could reduce demand for exports. Firms may need to plan ahead by hedging exchange rate movements or seeking to sell to domestic markets.
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November 18th, 2009 — economics
You are welcome to ask questions on Economics. I am looking to explain economic principles / ideas/ recent developments in economics. Due to the volume of questions, I can no longer promise to answer. But, I will try if it meets below criteria.
I will post the answer on this blog, for everyone to benefit from. I never email individual answers
Please Bear In Mind
- Use google custom search (top right) to see if question has been asked. If I have already answered a question I don’t tend to repeat it.
- The replies will be guidance and not for duplication. Your essays should be your own work.
- Don’t ask me to do your coursework / assignment e.t.c. The answer will be published here where your teacher can see it.
- My speciality is economics for British A Level standard.
- I don’t answer university questions or maths calculations
- I am looking to explain economic principles / ideas/ recent developments in economics.
- I will answer as a new post. Check home page of blog for new post. With question and answers
I studied PPE at Lady Margaret Hall college, Oxford University, and currently work as an Economics A Level teacher. I have also examined several different economic units for Edexcel AS and A2.
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November 18th, 2009 — economics
I have previously written about The Importance of Economics. It is one of those posts where there are an almost infinite number of topics to consider. This post will consider the importance of economics in our daily lives.
Economic Choices
We are constantly faced with choices. It may be a matter of limited time. For example, at the weekend
- We could spend 8 hours working in a cafe at the Minimum Wage of £3.57.
- Or we could spend 8 hours studying for our A – Levels.
- Alternatively, we could choose to spend 8 hours of leisure (sleeping in, facebook e.t.c.)
Each choice has an opportunity cost. The opportunity cost of earning 8*£3.57 £28.56 is that we don’t have time to study. This could lead to a lower Exam results, which could lead to lower future earning potential. Choosing to maximise our income in the short term (earning £30 a day) may reduce our lifetime earnings and could be a poor decision -unless working in a cafe doesn’t affect our future earnings. We may feel job experience more useful than an essay on allocative efficiency.
The problem is that when making decisions about whether to study, work or pursue leisure, we may forget or ignore long term effects. Deciding to spend all our free time earning £3.57 is something we may regret later in life. Economists suggest education is a merit good – meaning people may underestimate the benefits of studying. Underconsumption of education is an example of market failure.
Considering opportunity cost can help us make better decisions. If we act on instinct, we may choose the most pleasurable or easiest course of action, but the best decision in the short term may not be best in long term.
Importance of Macro Economy on Our Daily Lives
When making decisions we don’t tend to first look at leading economic indicators. But, perceptions about the economic outlook can influence certain decisions. For example, those aware of the current economic situation may be aware the depth of the recession which makes a period of low interest rates more likely. This suggests that if you could get a mortgage, mortgage payments would be cheaper, but, saving would give a poor return.
However, the bad state of the economy and high unemployment rate is a factor that may encourage students to stay on and study. Since youth unemployment is currently very high, it makes more sense to spend three years getting a degree rather than going straight on to the job market.
The only problem is that many other students are thinking the same. Hence the competition for university places is becoming much stronger. Another motivation to spend more time studying and less time working at Little Chef….
November 12th, 2009 — economics
One of the great challenges of Monetary and Fiscal Policy is knowing exactly where the economy is.
If output is falling, then this justifies an easing of monetary policy (lower interest rates, or in the UK’s current situation more quantitative easing). Recently GDP statistics showed an unexpected 0.4% fall in GDP. This was a key factor in encouraging the Bank of England to extend its policy of quantitative easing (creating money to buy more assets like gilts).
However, many are questioning whether the GDP statistics are correct. If GDP is not falling, but actually increasing, then the policy of extending quantitative easing could be damaging to the economy (e.g. create inflationary pressure, or another bond bubble)
Previously, the ONS has often later revised GDP statistics (quite often this involves revising them upwards. Though this year the ONS revised GDP to show a fall of 2.5 per cent from January to March — compared with an earlier reported decline of 1.9 per cent.). It seems that the ONS has difficult in calculating the size of the service sector, data is harder to collect here than it is in manufacturing.
But, whilst it is fine to revise statistics, you can’t change policy decisions.
One solution to this problem of incorrect statistics is to use a wider basket of statistics than just GDP. For example, some economists are pointing to
- slowdown in unemployment growth
- Improvement in Purchasing Managers Indices (Very accurate in predicting recession)
- improvement in consumer confidence
- Growth in manufacturing output
- Rise in house prices
Taking a wider look at the economy gives a better perspective and means policy will not be affected by one misleading statistic.
Nevertheless, it is not a huge concern. Though there are signs of recovery, it is from a very low base. GDP statistics may be better than the ONS state, but, I hardly feel inflation is becoming a pressing concern. GDP has still fallen over 6%.
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November 11th, 2009 — economics
Readers Question: How did the financial crisis affect stock markets and bond markets.
Stock markets were first hit by the instability in credit markets.
When financial markets realised the credit crunch would impact on the wider economy, shares in companies fell further. This is a typical response. When economies enter into recession, firms make less profit (or loss) and so firms pay lower dividends. This makes shares less attractive.
However, on the prospect of recovery, shares have bounced back from their nadir in November 2008. However, the London Stock Market is still 25% down on its Peak of 7000 just after millenium
The bond market is different to the stock market. Government bonds are seen as a ’safe investment’. Generally, in a period of uncertainty, investors prefer safe investments like government bonds. With shares, a firm could go bust. But, with government bonds – historically, they are safe.
Therefore, at the height of the credit crunch, there was strong demand for government bonds as people looked for security.
Government bonds have also been influenced by the policy of quantitative easing. This involves the creation of money to buy assets such as government bonds. Therefore Central Banks, especially the Bank of England, have been increasing their holding of government bonds. This has caused the price of bonds to rise, due to the increased demand.
However, the outlook for government bonds is more complicated.
Firstly, the recession and financial bailout has caused government borrowing to increase substantially. Therefore, there will be a lot of bonds, governments will be trying to sell. If the debt becomes too large, it may put upward pressure on interest rates and reduce the value of bonds.
Also, there will come a time when the economy recovers and the Central Banks halt and then reverse there policy of quantitative easing. This will involve selling their holdings of bonds on the open market. Combined with large fiscal deficits it is uncertain whether the market will have much appetite for the huge quantity of government bonds. Therefore, price of bonds may fall.
Some people, even talk of a new bond bubble. – Bond prices rising more than they deserve.
Related
Treasury Bond Bubble
Bond Yields and the price of Bonds
November 9th, 2009 — economics
Question: Why do we have a VAT rate of 17.5% on many ordinary goods and a tax rate on petrol / tobacco of over 50% – yet when people propose a tax of 0.01% on currency transactions it is denounced as unfair and economically damaging?
At the G20 summit, Gordon Brown, proposed a version of a Tobin Tax; he mentioned a tax on speculation. Yet, his proposals were quickly dismissed.
The original Tobin Tax proposed a tax of 1% on all currency transactions. The idea was that such a tax would increase the marginal cost of currency trades and so reduce speculation.
Such a tax could have two very significant benefits.
- Reduce speculation
- Raise Revenue. Many have suggested the revenue from a Tobin Tax could be used to finance projects in developing countries and so reduce global inequality. Even a very low tax (0.01%) on Sterling currency trades could raise £2bn a year.Alternatively the revenue could be used to deal with financial crisis, caused by speculation.
It is true a Tobin tax could have some limitations
- Difficult to collect as investors try to create new markets to avoid the tax
- It could reduce ‘hedging’ – a way to insure against exchange rate movements rather than speculation
- Difficult to administer.
- A tax could make markets more illiquid.
When the speculative tax was dismissed by ministers from Canada and US, the arguments used were rather feeble. – ‘We’re not in the business of raising taxes.’ ‘ not something we could support’
But, a Tobin tax does not have to raise overall revenue. Raise revenue from speculative taxes and other taxes could be lowered. Why should financial markets be immune from taxes?
I feel the main reason countries don’t want to introduce a Tobin tax, is the free rider problem. Countries are fearful that if they introduce a tax there will be some tax haven which will become the dominant financial market and they will just lose business. Therefore, no one wants to introduce it unless they are certain that it will be unilateral.
If true, this suggests that the rejection of a Tobin tax is a deadweight welfare loss for global society. If every country, placed a tax on speculative trades, the global economy would benefit. But, because we can’t be certain of international co-operation it is never introduced.
The other reason could be that financial interests hold a powerful sway over political decisions – despite the global economic crisis.
Personally, I’m in favour of a tax on currency trades and other speculative future trades. It would be a good way to raise revenue for development projects and for the World Bank to help finance bailouts.
It is unfortunate that it is unlikely to happen.
More on Tobin Tax
November 5th, 2009 — economics
Readers Question: Is it a good idea for the Baltic states to adopt the Euro before they have met the convergence criteria?
Latvia and Lithuania have a target date of 2013 for joining the Euro. Estonia by Jan 1 2011.
The four main convergence criteria for the joining the Euro are:
- Low inflation
- Low Government borrowing
- Stable Exchange Rate – no devaluations in past 2 years
- Interest rates – close to ECB interest rates
- more details at: convergence criteria
Problems of Joining Euro before Convergence Criteria are met
Interest rates unsuitable for Economy. Membership of the Euro involves a common interest rate for the whole Eurozone area, but, this interest rate may be unsuitable for countries who have not converged with the Eurozone.
Until 2008, Latvia was the fastest growing economy in Europe, with Real GDP growth touching double figures. This fast rate of growth may require a higher interest rate to prevent inflation. In 2007, Latvian inflation was running at 20%.
Since 2008, Latvia experienced a dramatic decline in output. Latvia’s GDP has declined 20%, with an extra 16% fall suggested. The IMF have suggested a devaluation to help stabilise the economy.
With such a volatile economy, joining the Euro could create significant problems. It would reduce the number of policy options available to Latvia
Also, Latvia has seen a rapid growth in government borrowing. Fears of bankruptcy have caused a credit rating downgrade to BB+. This means that it is more expensive to finance Latvian debt because of the greater risk involved.
It seems the Baltic countries are not just narrowly missing the convergence criteria but are facing a real economic crisis.
Joining the Euro may give an impression of exchange rate stability, but, it wouldn’t solve the underlying economic problems and imbalances. If anything, membership of the Euro would give less flexibility in dealing with its problems.
Also, if Latvia joined it would have implications for the existing Eurozone area.
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November 3rd, 2009 — economics
Readers Question: Is it possible the phenomenon to have a relationship between GDP and house prices where an increase of the mean GDP to lead to decreased house prices?
Yes,
An interesting phenomena is that UK house prices have shown an increase during 2009 – despite a prolonged recession.
Typically, in a recession, you would expect house prices to fall.
In particular a rise in unemployment often means people can’t afford mortgage payments, therefore, more houses are sold and prices fall. Confidence is also low, deterring people from buying
When the economy is growing and unemployment falling, demand for houses usually rises.
However, economic growth, is not the only factor that determines house prices.
House prices are rising in the middle of this recession because
- There is an acute shortage of houses on the market. Meaning that house prices are being pushed higher because of low supply (rather than rising demand)
- Interest rates are nearly 0%, meaning mortgages interest payments are low. Mortgage defaults have been lower than expected in 2009, because banks have tried to avoid repossesssion and very low interest rates have made mortgage payments easier to meet.
- House prices did fall 25% from their 2007 peak.
Could house prices fall when we have an economic recovery?
It is quite possible to envisage falling house prices during an economic recovery.
- Firstly, the rising prices may encourage many to put their house on the market (which they have been avoiding during past two years)
- Economic recovery will lead to inflation and therefore interest rates could rise from 0% to 5%. This means mortgage payments will rise causing many who just survived to struggle to meet mortgage payments.
- A large increase in supply could reduce prices during economic growth. Though, in the UK’s case a large increase in supply is unlikely to occur in the foreseeable future.
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November 2nd, 2009 — economics
Fear is a powerful emotion which can have significant economic implications.
Often real fears are ignored in a wave of over-exuberance. See: Economics of herding and irrational exuberance. Sometimes, if people had greater fear of getting into debt and falling asset prices e.t.c, the economy would be less prone to bubbles and the consequent mess. Perhaps fear isn’t the right word. – People just need greater awareness of the potential pitfalls of seemingly one way investment bets.
On the other hand, fear can create a powerful wave of pessimism and negativity which can prolong economic downturns and make it difficult to create an economic recovery.
The fear of future unemployment is a powerful motive which discourages spending and creates a paradox of thrift and liquidity trap.
For example, if people fear being made unemployed, they will be reluctant to spend even if interest rates are cut to 0.5%. This is one reason why interest rate cuts have not worked in creating an economic recovery.
Political Fears and Economic Fears.
Political campaigning is often most successful when focusing on people’s fears. But, politicians may exaggerate certain fears and concentrate on the wrong problem.
For example, there are many problems currently facing the UK Economy.
One of these is the size of the budget deficit. Certainly a budget deficit of £200bn in one fiscal year is no insignificant problem. Yet, the depth of the recession is arguably even more serious.
A report by Fathom Consulting argues that the Conservatives plans to cut spending may cause serious problems for economic growth and push the economy back into recession. (link at Telegraph)
In other words, we need to be concerned about the problem of rising levels of government borrowing, but, we have to keep things in perspective and worry about the biggest problem first. It can be dangerous to fear one problem ignoring other issues.
Another example, is the fear of inflation. When Quantitative easing was announced, some immediately feared future inflation. But, recent money supply figures suggest inflationary pressures are almost non-existent. In other words, it can be dangerous to fear the wrong thing (perhaps a lesson for the ECB)
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November 2nd, 2009 — economics
Readers Question: Hi – I hope to explain the fiscal multiplier effect to a bunch of non-economists (business professionals). I’m planning to start with the Keynesian GDP equation and work from there. Where I am stumped is how to represent the effect of a reduction in tax (lump sum or whatever) on the GDP equation.
AD = C+I + G + X – M
The multiplier effect states than an injection (e.g. government spending) into the economy can lead to a bigger final increase on Real GDP. E.g. if Government spending of £1bn led to an increase in real GDP of £1.5bn, the multiplier effect would be 1.5
- A tax cut has no effect on government spending, but, it should effect C and I.
- For example, imagine the government cut VAT from 17.5% to 15%. This has two effects.
- Firstly, if consumers maintain the same spending habits, they will have more disposable income left over to buy more goods. Secondly, they may be encouraged to buy goods (especially expensive electrical goods) e.t.c because they are cheaper.
- Therefore, in theory, a tax cut should boost consumer spending and this leads to an overall rise in AD.
- This means firms will get an increase in orders and sell more goods. This increase in output, will encourage some firms to hire more workers to meet higher demand. Therefore, these workers will now have higher incomes and they will spend more. This is why there is a multiplier effect. Extra spending benefits others in the economy.
The size of the multiplier will depend on what % of the extra income people spend on UK goods.
For example, if people buy imports or save the extra money, the multiplier will be limited.
Monetarists argue the fiscal multiplier will be limited by the crowding out effect. E.g. governments increase AD through higher spending or tax cuts, but, the rise in borrowing leads to a decline in private sector investment. Therefore, there is no overall increase in AD.
However, in a recession, the private sector typically has a glut of non productive savings, therefore, the crowding out effect is limited.
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