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Should we increase the state pension age?

By Tejvan Pettinger on December 5, 2013 in labour markets

Many Western economies face a demographic time bomb – an ageing population, which places strain on government spending and the welfare state. To deal with this situation, governments face several difficult choices -

Raise taxes to pay for pensions,
Shift the emphasis on to the private sector provision of pensions,
Raise the retirement age
Cut other forms of spending to be able to maintain pension commitments.

Recently, the UK chancellor George Osborne, has suggested that he favours a solution which involves automatically linking state pension to life expectancy; this could see the state retirement age, increasing to 70. It is estimated, this could save up to £500bn over 50 years; there would be a very significant opportunity cost to keeping the retirement age at 65.

However, others are more critical of increasing the retirement age. They argue that raising the retirement age will adversely affect low income workers who find it more difficult to save for a private pension. Also, some economists question whether we really have a demographic time bomb, and argue that the fears of an ageing population are exaggerated.

The extent of the problem

The dependency ratio is the ratio of people who are not of working age compared to those who are of working age. If there is a higher % of pensioners then the dependency ratio will rise. Basically a higher dependency ratio means a relatively greater number of benefit recipients to tax payers.

dependency

Source: Dept for work and Pensions

This graph shows that all Western economies face a rise in the dependency ratio (assuming a retirement age of 65). However, the UK’s demographic forecast is not as bad as other countries. This is partly because the UK has had significant levels of immigration and an increase in the population.

Arguments for raising the pension age to 70

1. Increasing life expectancy . Increasing life expectancy means that it makes sense to raise the retirement age. When the first state pensions were introduced in 1908, the pension age was set at 70. It was later reduced to 65. But, since the start of the Twentieth Century, we have seen a rapid increase in life expectancy. It means that people are living for longer. If we keep the retirement age the same, we are trying to support an ever increasing % of people’s life in retirement. Rather than seeing it as a bad thing the retirement age is increasing, we should see it as a good thing we are enjoying greater life expectancy. Since 1981, longevity has increased 5.3 years

2. Higher tax revenue. As well as saving the government pension spending, if people work longer it will increase income tax revenues. Increasing the labour supply will also increase the productive capacity of the economy.

3. Will enable the government to increase the value of the state pension. If the retirement age is increased, the government will be able to afford an increase in the real value of the state pension. A higher basic state pension will help reduce poverty without creating disincentives to save that means tested top up benefits do. People may prefer a decent pension spread over a smaller number of years than a limited pension stretched over a longer time period.

3. More flexible labour markets. At the moment, several professions have a fixed retirement age; this means people have to retire at a certain age, even if they would prefer to keep working. Increasing the state pension age, will enable people to work longer. It may be that people work part time towards the end of their working life, but it will help increase the supply of labour. With jobs increasingly non-manual, there isn’t any physical barrier for people to keep working. It means the economy can benefit from highly experienced and highly skilled workers.

4. Better than the alternatives. The alternatives to increasing the retirement age are also unattractive. It would entail placing a higher tax burden on the working population; these higher tax rates could reduce incentives to work. Continue Reading →

Different Types of Inflation

By Tejvan Pettinger on December 4, 2013 in inflation

Inflation means a sustained increase in the general price level. However, this increase in the cost of living can be caused by different factors. The main two types of inflation are

Demand pull inflation – this occurs when the economy grows quickly and starts to ‘overheat’ – Aggregate demand (AD) will be increasing faster than aggregate supply (LRAS).
Cost push inflation – this occurs when there is a rise in the price of raw materials, higher taxes, e.t.c

1. Demand Pull Inflation

This occurs when AD increases at a faster rate than AS. Demand pull inflation will typically occur when the economy is growing faster than the long run trend rate of growth. If demand exceeds supply, firms will respond by pushing up prices.

Simple diagram showing demand pull inflation

The UK experienced demand pull inflation during the Lawson boom of the late 1980s. Fuelled by rising house prices, high consumer confidence and tax cuts, the economy was growing by 5% a year, but this caused supply bottlenecks and firms responded by increasing prices.

This graph shows inflation and economic growth in the UK during the 1980s. High growth in 1987, 1988 of 4-5% caused an increase in the inflation rate. It was only when the economy went into recession in 1990 and 1991, that we saw a fall in the inflation rate.

2. Cost Push Inflation

This occurs when there is an increase in the cost of production for firms causing aggregate supply to shift to the left. Cost push inflation could be caused by rising energy and commodity prices. See: Cost Push inflation

Simple Diagram showing cost push inflation.

Example of Cost push inflation in the UK

In early 2008, the UK economy entered a deep recession(GDP fell 6%). However, at the same time, we experienced a rise in inflation. This inflation was definitely not due to demand side factors; it was due to cost push factors, such as rising oil prices, rising taxes and rising import prices (as a result of depreciation in the Pound) By 2013, cost push factors had mostly disappeared and inflation had fallen back to its target of 2%.

Sometimes cost push inflation is known as the ‘wrong type of inflation‘ because this inflation is associated with falling living standards. It is hard for the Central Bank to deal with cost push inflation because they face both inflation and falling output. Continue Reading →

Application and Interview Tips for PPE at Oxford University

By Tejvan Pettinger on November 28, 2013 in economics

I studied PPE at Lady Margaret Hall, Oxford university between 1995-99. Quite often people ask me for tips on applying and the interview, so here are a few suggestions.

Radcliffe Camera, Oxford University. Photo Tejvan

Preparation

A good reading list is important. Some suggestions here: PPE reading list
But, also do follow your own interests. If it was me, I would veer towards recent economics books such as this Economics Summer reading list
CV – mainly about your academic studies. Need to show why you would be a good interesting candidate.

Interview Tips

Be prepared to speak about any books / interests you mention in your personal statement.

A good preparation would be to practise summarising some of your reading list. This helps you to remember what you read, but also the ability to summarise a book is a key element of PPE. (I remember very long reading lists, the ability to condense information was vital)

The interviewers are looking for people who will be interesting and rewarding to teach. A good student will have the following qualities.

Interested in the subject.
Able to effectively argue and explain subject material.
Ability to think for themselves and come to reasoned conclusions.
Confident in the ability to discuss concepts, but also a degree of humility. You’ve come to learn, not to know everything already.
Sense of reliability and good manners.
Respond to follow up questions.
Don’t worry if you slightly alter your opinion / position in response to follow up questions. But, equally avoid temptation to automatically agree with the interviewer – they don’t want obedience. An interviewer, may well take up a position they don’t believe in, just to create a debate.

Continue Reading →

Economics of Scottish Independence

By Tejvan Pettinger on November 27, 2013 in economics

A look at the pros and cons of Scottish independence from an economic perspective.

It is said you can’t put a price on freedom and cultural identity. But, when it comes to independence, economics seems to be one of the biggest factors to sway voters in Scotland. When asked in a poll, only 21% favour Scottish Independence if it leaves them £500 a year worse off. Only 24% favour retaining union with Britain if it leaves them worse off. (Economist)

Benefits of Scottish Independence

Oil and Gas Reserves in the North Sea are potentially a lucrative source of tax revenue and this has become more profitable with higher oil prices. According to the Scottish government, Scotland represents 8.4 per cent of the UK’s total population, but they generate 9.4 per cent of its annual revenues in tax — equivalent to £1,000 extra per person. (link) However, with dwindling reserves, income from oil and gas may dry up in future years.
Independence may give freedom to set low corporation tax rate and attract business from overseas.
Reform of tax and welfare system. Crawford Beveridge, chairman of the Scottish Fiscal Commission, claims that smaller countries, such as Ireland and New Zealand have considerable success in collecting tax. He argues an independent Scotland could scrap 1,000 tax exemptions and make the tax system simpler and encourage greater work incentives. “The UK tax system is complex and costly, and does not fully reflect the unique characteristics and needs of Scotland. There is considerable room for improvement in its design and operation.”
Some argue that independence might increase self-confidence of the country, attracting more business and tourism. It may enable Scotland to have a stronger brand loyalty for its traditional exports like whisky and tartan kilts.

Costs of Scottish Independence

Would lose ‘subsidy’ from Westminster. Scottish people get around £10,212 spent on them every year by the UK government, compared with around £8,588 — £1,624 less — for people in England. Independence may make it more difficult to maintain this spending. Independence may end some of the generous subsidies in Scotland for university education, trains and health care. However, this Scottish ‘subsidy’ is controversial as oil and gas revenues help give a Scotland bigger (£1,000) per capita tax revenue (New Statesman)
Debt Levels. After independence, UK debt levels would be share on a per capita or per GDP level. This would leave Scotland with a national debt of £80bn and growing. Although debt would be split according to the respective GDP, the recent experience of smaller countries on the Eurozone periphery mean that Scotland may struggle to meet debt payments Continue Reading →

Did the government use the right policies to reduce the budget deficit?

By Tejvan Pettinger on November 26, 2013 in economics

Readers Question: Do you believe the Coalition Government has used the right macroeconomic policies with regards to reducing the budget deficit?

No. I’ve written a few times that I believe the coalition government made a big mistake in prioritising deficit reduction over economic recovery in 2010.

The consequence of trying to reduce the budget deficit at the wrong time (in a recession) is lost output, higher unemployment and falling real wages. Austerity wasn’t the only reason for the double dip of 2011. The weakness of the EU economy was a major factor. But, government austerity did adversely affect demand and confidence.

See: How austerity affects the economy

The main thing that can be said about the UK is that the austerity was relatively mild – spending cuts were a small % of GDP compared to European austerity. Combined with a loose monetary policy, UK recovery is currently better than many European economies.

Doesn’t the current economic recovery of 2013 prove that the government were correct?

Source: ONS

During 2013, the UK economy shows signs of recovery and appears to be one of the ‘strongest’ economies in Europe. This could be taken as a sign that the government got it right. But, I would look at it in a different way. Even with austerity policies, the economy will eventually recover. But, the economy could have recovered sooner. If the economy had recovered sooner, wages may have risen earlier, unemployment would be lower. Also with an earlier recovery, the government cyclical tax revenues would be in a stronger position.

If we hadn’t pursued austerity wouldn’t we have had a bond crisis and unsustainable deficit?

If we had run larger budget deficit, public sector debt would be slightly higher. For example, if we had borrowed an extra £20 billion to invest in public sector investment, rather than a public sector debt of £1,211.8 billion (75.9%) of GDP -we might have had a debt £1,231 billion (76.1% of GDP)But, it’s not a huge difference in the long run.

But, this borrowing of £20 billion, would also have helped improve tax revenues. And the economic growth, would help public finances in the long term. Stronger recovery would mean that the government cut spending later with less impact on economic growth. Borrowing costs have been very cheap for the government. With an independent Central Bank there was never a chance of a bond crisis like Euro members faced.

Has government fiscal policy been offset by monetary policy?

Given the looseness of monetary policy, the devaluation in the Pound, you would expect a recovery at some stage. I would say, that the willingness of the Bank of England to tolerate above target inflation and keep pursuing monetary expansion has definitely offset the (relatively minor) fiscal contraction of the government. In this case, the UK has been relatively lucky compared to Eurozone economies. Southern Eurozone economies have pursued fiscal austerity, whilst at the same time had an ECB committed rigidly to low inflation. The consequence is European deflation

Does it matter to keep criticising past mistakes?

Yes. As an economist, you feel this recession offered a classic textbook case of where fiscal policy was needed to play a role in economic recovery. In a recession, with zero interest rates, the government can and should be willing to offset the decline in private sector spending and investment.

The problem is that there is a strong political attachment to austerity. See: why is austerity politically popular

The idea that we ‘deserve’ austerity after the years of excess.
The idea that good housekeeping means reducing budget deficits no matter the state of the economy.

If we are not careful, unnecessary austerity policies are being vindicated as successful. We only suffered for five years! Our policies are a success because eventually there was a recovery.

For a more balanced post with arguments for and against deficit reduction. See: Should pace of deficit reduction be slowed?

Related

UK Inflation Rate and Graphs

By Tejvan Pettinger on November 25, 2013 in A-Level, economics, stats

Current UK Inflation Rate

CPI inflation rate: 2.2% (headline rate)
CPIH grew by 2.0% in the year to October 2013 (CPIH includes household costs, such as mortgage payments)
RPIJ grew by 1.9%, down from 2.5%
Inflation is a measure of the annual % change in the cost of living. (page updated Nov 23, 2013)

The largest contributions to the fall in the rate came from the transport (notably motor fuels) and education (tuition fees) sectors.
Raw data inflation time series | CPI annual % change at ONS

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

Continue Reading →

Factors that affect the cost of private renting

By Tejvan Pettinger on November 21, 2013 in housing

Readers Question: I was looking for info on housing demand/supply. One area you have no info on is rental trends. There is a lot written about a critical housing shortage in the UK, starting with the Kate Barker review (2004), who took great pains to assure anyone who asked that UK house prices could only go up because of supply/demand fundamentals. None of her projections have been achieved and, if her assumptions were right, there should be an acute housing shortage, evidenced by rising rocketing rental rates, and middle-class homeless, sleeping on the street. Anecdotally, I don’t see any manifestation of exponential inflation of rents eg a 2 bed apartment in the commuter belt outside London attracted rent of c. £1,000 pm in 2002. In ten years that has risen marginally. Why, if there is a critical housing shortage?

The ONS have started a new private housing rental price index – Index of private housing rental at ONS Data only goes back to 2005.

In recent months, there has been a marginal increase in house price rents in UK.

In the 12 months to August 2013 private rental prices paid by tenants in Great Britain rose by 1.2%. Private rents in Great Britain excluding London rose by 0.8% during the same period.
In the 12 months to August 2013 private rental prices grew by 1.1% in England, 1.3% in Scotland and 1.3% in Wales.

Index of renting

I used statistics for England rents because the data went furthest back. Data for the UK started later. Source: ONS

This shows a modest rise in the cost of house price rents. A rough calculation suggests an 8-9% rise in rental prices, slightly lower than the rise in the Consumer price index.

House price v rental costs

An interesting comparison is to compare house price inflation with the increase in rental prices.

One very clear feature is that house price inflation is much more volatile than rental prices. Rental inflation, has rarely risen above 2%, House price inflation has reached over 10%, and slumped to -13%

In this period since 2006, house prices have risen by an average of 2.4% . Rental prices have risen by an average of 1.0%

However, it is worth bearing in mind that in the period 2000-2006 house prices were increasing by up to 20% a year.

In a way, it is remarkable, that house prices have risen by an average of 2.4% since 2006 – given the credit crunch, the depth of the recession and espeically when compared to other countries which have had a real housing slump, such as Spain and the US.

UK House prices to rental costs

The Federal Reserve have an interesting graph which shows how house prices in the UK have risen much more substantially than UK private rents, in the period 1996-2008.

FRB on UK House prices (2008) It was interesting the FRB report suggested ‘Using the price-rent ratio as a guide, (UK) house prices are likely to fall at least a further 30 percent before levelling off.’

Why are rental prices more stable than house prices?

Some factors that could explain why UK house prices have been rising faster than rental prices.

Many tenants have longer term contracts. Landlords may enter into agreements (either formal or informal) to keep rental prices fairly constant. House prices, by contrast, are driven by supply and demand. If more people enter the market for buying a house, it can push prices higher. If house prices rise 20%, it doesn’t mean homeowners will see a 20% rise in the cost of mortgage payments. Most homeowners will be unaffected in the short term by rising house prices. Renters will be affected directly by any change in the cost of rent. Most renters couldn’t afford more a sharp jump in rents.
Rents not affected by interest rates. If interest rates go up, this doesn’t change the cost of renting. But, it might dissuade people from buying a house. Similarly if interest rates fall, landlords will not pass the interest rate cut onto tenants.
Supply more elastic. It is likely that rental properties are slightly more elastic than houses. If there is greater demand for renting, and the price of renting goes up, it may encourage more landlords to put houses for rent on the market or it may encourage people to let out a room. However, this point is just an assumption – it would need a bit more investigation.
Demand more price elastic for renting. If rents rise in London, it may encourage workers to move elsewhere to find cheaper rents. Renters are more flexible and more price sensitive. If you want to buy a house in a certain area, you’re demand is more likely to be price inelastic. If house prices go up, you may be willing to pay the higher price – you don’t notice a price rise straight away. Higher prices are spread over the 30 years of the mortgage term.
Buying houses as investment. Rising house prices have encouraged more people to buy houses as an investment. This pushes up house prices, but consequently leads to an increase in the supply of rented accommodation. Therefore, you could have a situation where a sharp increase in buy to let activity, pushes up house prices, but decreases rental prices. Evidence suggests the % of homes which are owner occupied has declined in recent years; this could imply an increase in the supply of homes put on the rental market. Continue Reading →

Externalities and the free market

By Tejvan Pettinger on November 18, 2013 in economics

Readers Question: I understand “externalities” and why certain economic actors will tend to dispute the scale/existence of them. What about the complementary idea, of benefits conferred by many societies which are centrally planned and financed (roads, defence etc.)? Libertarians of any political stripe may downplay/deny their importance though benefitting. My question: is there a technical term for all this? “Internalities” would be logical. Some of these are easier to perceive and defend than others. Roads are “good”. NHS more controversial. Hardest to define, benefits of a society which is liberal, promotes trust, provides robust safety net etc. Thanks, Mark

I’m sure most economists would accept the existence of externalities, both negative and positive. If there are negative and positive externalities, there is a clear argument that this will lead to market failure. For example:

I would argue that health care is a clear case of a service which has a strong positive externality. If you look at standards of public health in the Ninenteenth Century, death rates were much higher. It is in everyone’s interest to provide a minimum level of public health because everyone benefits. If you have a situation where people catch infectious disease because the free market has failed to provide decent sewage or vaccination, everyone is more susceptible to catching infection too.

Solution to Externalities

The solution to externalities may differ. I’m not too aware of extreme Libertarian ideas because I find it difficult to take them too seriously. I know the presidential candidate Ron Paul argued there was no need for public health care because in the absence of government, local communities would chip together to offer local charitable provision.

A libertarian may also argue, that even if there is a theoretical case for government intervention to overcome market failure, the government should still nothing. The argument is that the costs of government intervention (such as incentive reducing income taxes), poor information, and the ‘inevitable’ government corruption will always outweigh the benefit.

Personally, I don’t accept this idea. Health care workers, such as nurses and doctors don’t become inefficient because they are working for the government NHS rather than a profit making health firm. In fact, perhaps the opposite. Continue Reading →

The depth of the European recession

By Tejvan Pettinger on November 15, 2013 in euro, unemployment

Interesting graph which shows the depth of the EU recession compared to the great depression of the 1930s.

Source stats | via Krugman

UK recession compared

This graph is from the start of 2013. Since, then the UK economy is showing signs of picking up. But, it is still worth bearing in mind the length of the decline in GDP since the start of the recession.

recessions-different-recoveries

Comparing different recessions

For the first 15 months, the decline in real GDP is comparable to the great depression of the 1930s. The great depression shows a bigger fall in GDP (-8.0%) from peak. But, during the 2008- recession, GDP stagnated the longest. Continue Reading →

Causes of Europe’s deflation problem

By Tejvan Pettinger on November 13, 2013 in euro

The European Union is facing the prospect of a serious bout of deflation (or at least, very low rates of inflation / disinflation) Deflation occurs when prices fall. But, very low rates of inflation are considered to raise problems associated with deflation.

In the Eurozone, the main index of inflation has fallen to 0.7% - This is well below the ECB’s inflation target of 2%. Some regions and countries in the Euro, such as Greece are already experiencing deflation. In Greece prices fell 1.8% last year and the consumer price index reached the lowest level for 51 years (FT Link). Spain and Italy in particular, are nervous about the prospects of experiencing deflation in the future.

Inflation ECB – Inflation has since fallen to 0.7%

Causes of deflation in Europe

Eurozone-unemployment

1. Unemployment. Unemployment in Europe has increased significantly since 2008, with the unemployment rate now reaching 12.2%. High rates of unemployment put downward pressure on wages, as the unemployed are more likely to accept lower wages.

2. Internal devaluation. A striking feature of the Euro is that countries which became uncompetitive in the boom period, can not devalue their currency to regain competitiveness. Therefore, the only option is for them to pursue internal devaluation. This means reducing prices and costs in the economy – primarily cutting wages. By reducing costs, they can make their exports more competitive and regain competitiveness. But, with weak external demand, it is proving a difficult and slow process for southern Europe to restore competitiveness compared to northern Europe.

3. Weak demand. The fundamental cause of deflation is weak demand within the Eurozone. Firstly, several Eurozone economies are pursuing fiscal austerity to try and reduce budget deficits. These spending cuts and tax increases are causing a significant drop in demand. Because of the relatively tight monetary policy, and strong Euro, demand is not coming from other sectors of the economy.

4. Fear of inflation in Germany. With inflation falling to 0.7% and unemployment of 12%, you would expect economists to be unanimous in the desire to overcome the threat of deflation and promote growth in Europe. But, in Germany the prevailing economic orthodoxy is still to worry about inflationary pressures and a possible loss of ‘confidence’ – should the ECB promote monetary loosening. Recently The ECB cut interest rates by 25 basis points, after the fall in inflation rate from 1.1 to 0.7%, but several Germany economists dissented arguing that it is wrong to cut interest rates given the possibility of ‘inflationary’ pressures in Germany. In the past, Angela Merkel has argued that Germany would need an interest rate increase if the German economy was taken in isolation. (FT link) The underlying fear of inflation means there is tension within the ECB and a reluctance to loosen monetary policy to target deflation.

Source: Eurostat: via Krugman Continue Reading →

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