Archive | economics

Government Spending under Labour

During the years 1997-2007, there was a significant rise in government spending, though as a % of GDP the rise was less marked.

UK-government-spending

Source: ONS Public Sector Finances MF6U – October 2014

Government spending as a % of GDP

A more meaningful comparison is to look at the share of government spending as a % of GDP.

g-spending-percent-gpd-96-14

  • In 1996-97 – Government spending as a % of GDP 40%
  • In 2007/08 – Government spending – 41% of GDP
  • In 2008/09 – 44.5 % of GDP

The large increase in government spending as a % of GDP in 2008/09 was a direct result of the deep recession. In a recession GDP falls, tax revenues fall and government spending on benefits rise.

Public sector debt

uk-national-debt

In 2007, UK public sector debt was close to a historical low ( post 1914) .

public-sector-debt-ons

More detail at: UK national debt

A more detailed graph of that period. Shows that public sector debt went from 42% of GDP in 1997 to 50% by 2010.

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The effect of tax cuts

Question: What are the effects of reducing tax?

Let us take the example of a cut in the basic rate of UK income tax from 20% to 18%

In this case, workers will see an increase in their discretionary income. With lower income tax rates, they would keep more of their gross income, so effectively they have more money to spend.

In this case, we could expect to see a rise in consumer spending because workers are better off. (AD=C+I+G+X-M). Because consumers spending is a component of AD (roughly 60%) then a rise in consumer spending should cause a rise in aggregate demand (leading to higher economic growth)
AD-increaseBut, does a cut in tax really increase aggregate demand? Firstly, it depends how the tax cut is financed.

  • Suppose the government offer £4 billion of income tax cuts, but at the same time cut £4 billion from welfare spending. In other words the tax cut is financed by cuts in government spending. In this case, we will not see an increase in AD because some people are better off from the tax cut, but others will cut their spending due to lower welfare payments.
  • Alternatively, the government could finance the tax cut by increasing government borrowing. Would this increase AD?
    • In a recession, we probably would see higher AD. This is because the government borrowing will be financed by people wanting to save anyway. In this case, the government is injecting unused resources into the circular flow. In a recession,  the tax cut makes a big difference to people’s spending power
    • If the government increases borrowing in a boom to finance a tax cut, we may get crowding out. This essentially means the government borrow more by selling bonds to the private sector. If the private sector buy government bonds, they have less money to invest elsewhere. Also, during high growth, higher borrowing may lead to higher bond yields and these higher interest rates cause financial crowding out.
  • If the tax cut is financed by by higher productivity, rising tax revenues, and a growing economy, then this is more likely to allow higher consumer spending.

Impact on Productivity

If we take a cut in income tax, it could also have an effect on the supply side of the economy.

  • Lower income tax rates may encourage people to work longer. Overtime is more worthwhile if you get to keep more of your income. This is the substitution effect – work is more attractive with lower tax rates.
  • However, there is also the income effect. With lower tax rates (and effectively higher wages), it is easier to get your target income by working fewer hours. Therefore, tax cuts may not increase labour supply because people don’t need to work more, if work is more highly paid.

There is much debate about the extent to which tax cuts increase productivity and economic growth. If marginal tax rates are very high e.g. 80%, cutting tax rates is likely to have some increase in labour supply and productivity. But, with tax rates of 20 or 30%, cutting income tax rates is no guarantee of increasing productivity and growth.

Cut in indirect tax

If the government cut an indirect tax like VAT, the effect is similar. If goods are cheaper because of lower tax, consumers will effectively have more purchasing power. After buying the same number of goods, they will have more money left over, therefore consumer spending may rise.

Again the effect depends on the state of the economy.

For example, cutting VAT at the start of the recession was expansionary fiscal policy and helped to make consumer spending higher than it otherwise would have been.

Other impacts of a cut in tax?

  1. It depends on consumer and business confidence. If consumer confidence is low, then a cut in tax may not increase spending because they prefer to save the extra income. Alternatively, some argue, that lower tax will increase confidence and general motivation because they feel less government intervention.
  2. It depends what else is happening in the economy. If we cut tax, during a global recession, AD may continue to fall. Even though tax cuts are helping to increase disposable income, we will see a fall in exports, fall in house prices, and a rise in unemployment. In other words, the expansionary effects of tax cuts are outweighed by other factors in the economy.
  3. It depends which taxes are cut. If you cut excise duty on alcohol and tobacco, then many people on low income will see a significant increase in discretionary income, this is likely to be spent. If you cut higher marginal tax rates (e.g. 50% tax rate on incomes over £100,000) this is more likely to be saved. People earning over £100,000 have a lower marginal propensity to consume – they can afford to save. Therefore, if you cut tax for high earners, there will be a smaller impact on increasing AD, than cutting tax for low income earners.

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Different ideas of tight monetary policy

Readers Question: I only recently discovered your site, which is spectacular, and have been reading every article since then. However, I found that two of your articles are contradicting. In your article “Problems of Deflation” you state that the current monetary policy of the EU is tight due to 0.5% inflation and interest rates.

In your article about tight monetary policy though, you state that tight monetary policy could include open market operations and rising interest rates.

I was hoping that you would help me solve my misunderstanding.

It is a good question. Firstly tightening of monetary policy implies that the Central Bank is trying to reduce demand for money – and reduce the rate of economic growth. Tight monetary policy implies high real interest rates. Tightening of monetary policy usually involves higher real interest rates.

The most simple example of tight monetary policy would involve increasing interest rates.

  • Higher interest rates increase the cost of borrowing, increase the cost of mortgage payments and reduce disposable income – this leads to lower consumer spending and lower economic growth
  • Alternatively in theory, the Central Bank could try and reduce the money supply. For example, printing less money, or sell long dated government bonds to banking sector. This is very roughly the opposite of quantitative easing. Though open market operations haven’t been used in practise for quite a while.

How can you have tight monetary policy with low interest rates?

inflation-base-rates-since-03

A potential confusion is why do economists talk about tight monetary policy when interest rates are 0.5% or zero – like in the current climate?

If you have a quick glance of an economics textbook, zero interest rates imply loose monetary policy – low interest rates make borrowing cheap, mortgages cheap, and in theory should encourage spending and a higher rate of economic growth. Continue Reading →

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UK Inflation Rate and Graphs

Current UK Inflation Rate

  • CPI inflation rate: 0.0% (headline rate)
  • (page updated 25 March, 2015)

inflation-monthly-target

What is causing the fall in inflation?

  • Lower cost push inflation – falling oil prices
  • Other commodity prices also falling, such as metals, food.
  • Lower energy prices – gas and electricity
  • Low worldwide inflationary expectations. Europe is experiencing deflation and this is keeping inflation low.
  • Supermarket price wars, with big chains, such as Tesco and Sainsbury attempting to maintain market share from Pound Shops and discounters like Lidl
  • Wage growth still weak, despite early signs of some wage growth.
  • Note: RPI inflation is still 1.0%. Also, core inflation stripping out volatile items such as petrol, oil and energy prices is higher than the headline CPI rate.

Historic inflation

uk-RPI-inflation-1948-2014

The current UK inflation rate compares favourable to much of the post-war period. The 1970s frequently saw double digit inflation. In 2014, the annual RPI was 2.2%.

See also: more historical graphs of inflation

Inflation since 1990

inflation-monthly-cpi-90-15-with-target

CPI and CPIH

  • CPIH – 0.3% in the year to Feb 2015

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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Fall in Euro

Recently, the Euro has fallen from 1.5 Dollars to 1 Euro in 2011 to near parity in March 2015.

Fall in Euro

The fall in the value of the Euro has been very steep in the last six months.

This is a very significant depreciation in the Euro, and primarily reflects the greater economic weakness in the Eurozone. Related to the economic weakness, is the decision of the Eurozone to recently begin expansionary monetary policy (quantitative easing).

Why the Euro is falling

1. The ECB are embarking on Quantitative easing – the creation of money to purchase government bonds. Quantatitive easing tends to reduce the value of a currency because:

  • This increase in the money supply tends to reduce the value of the currency (greater supply tends to reduce price.)
  • Q.E raises expectations of higher inflation  – higher inflation tends to reduce the value of a currency because it will become less attractive to buy EU goods.
  • Also purchasing government bonds will reduce bond yields in Europe, making it less attractive for private investors to save money in the Eurozone – you get a lower return on Eurozone assets. Investors would rather save in US assets, where interest rates are more likely to rise and you will get a better rate of return.

2. General weakness of the Eurozone economy. Some analysts believe that EU’s quantitative easing maybe a case of too little too late; they believe Q.E. in Europe may actually have a quite limited effect. This is due to two factors: Continue Reading →

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Venezuela economy and oil dependency

A look at why the Venezuela economy is dependent on oil, why it did not do more to diversify, and the problems of relying on a primary product like oil.

Readers Question: First, why are more than 90% of their exports based on oil? Under Hofstede’s “Uncertainty and Avoidance of Risk”, Venezuela is ranked as a country that goes to great lengths to avoid risk. But basing an entire economy on the prosperity of one commodity seems like the definition of risk. Your thoughts on that are much appreciated.

Firstly a few quick statistics on Venezuela economy. According to Wikipedia

  • Venezuela is an oil dependent economy. Revenue from petroleum exports accounts for more than 50% of the country’s GDP and roughly 95% of total exports.
  • Manufacturing contributed 17% of GDP in 2006
  • Agriculture in Venezuela accounts for approximately 3% of GDP, 10% of the labor force.

Why does an economy base its prosperity around one commodity?

Firstly, Venezuela is not unique. Many countries specialise in oil and then later come to regret this specialisation. I have a Russian student who is asking exactly the same question – Why did Russia not take the opportunity to diversify away from gas and oil. (see: Russian economic crisis)

The problem is that when oil prices are high, it’s tempting to take advantage of the high revenues. Anything else seems much less profitable. Secondly, people may make the assumption oil prices will remain high – so they have plenty of time before needing to diversify the economy.

If you have vast reserves, then in the short term, oil production offers the quickest way to promote economic prosperity, higher tax revenues and higher government spending. By comparison, at the time, manufacturing and agriculture will offer much smaller returns and potential for exports.

In 2007, when oil prices were rising, the Venezuela economy was growing rapidly – 7% a year. With oil revenues, the government was able to begin ambitious spending programmes. Many in 2007/08 may have felt that high oil prices were likely to stay high. (I remember reading articles which predicted oil prices of $200 a barrel. Very few were predicting a collapse in prices to $40.

crude oil prices

St Louis Fed

Why not diversify the economy?

It is easy to say than do. If you have an economy that has a highly profitable oil industry, it is difficult to develop new manufacturing industries. This is for a few reasons.

  • The profitable oil industry will be attracting most investment and skilled labour.
  • Entrepreneurs will be reluctant to create new industries, where Venezuela doesn’t seem to have a comparative advantage; the prospect of profit is low and there is no guarantee they will be able to create new industries. Trying to work in the oil industry may seem more appealing and profitable.
  • The government, in theory could try to diversify the economy. They could tax the oil industry and use the proceeds to subsidise the creation of new manufacturing industry. However, around the world, governments don’t have a great track record of ‘setting up new industries’ – The government is not expert in manufacturing and so it may struggle to decide which industries to create and where to spend money. There is no guarantee the government efforts to subsidise new industries will bear any fruit. Many governments would prefer to take the easier option of benefiting from boom in oil industry and hope the oil price stays high.
  • Governments are not noted for long-term vision and acting on the possibility of changing economic situations. The political process also encourages a short-termism. You don’t tend to win many elections by promising lower income now, and investment which may bear fruit 5-10 years in the future.

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Greece could benefit from leaving the Euro?

Just a short post, inspired by this article by Hamish McRae in Independent – Would it Matter if Greece left the Euro?

So often governments have fought ‘tough and nail’ to stay in an exchange rate system. But, when they finally leave – it is the best thing they ever did, and you’re left thinking – if only they left earlier, it would have saved economic pain. For example:

We don’t really know what would happen if you left the Euro – it is uncharted territory. We can only speculate on potential outcomes. But, perhaps this makes us more conservative and highlight the dangers of leaving.

However, given the Euro has been such an unmitigated disaster for Greece.

  • GDP down from $340bn in 2009 to $240bn 2014.
  • Unemployment of 25%

Could it get any worse?

In the short-term, quite probably. But, is the short term pain not worth becoming masters of your own economic and political destiny?

Greece may lose out in the short term. But, in the long term it will enable them to have their own currency, own monetary policy and own fiscal policy. This should give better prospects of long-term prosperity and economic stability.

The cost of staying in

Suppose Greece does endure another decade of austerity and finally returns to normal growth. Is there any guarantee the crisis of 2007-2015 will not return, at some point? It is quite likely. There is an inbuilt deflationary bias in the Eurozone. The Greek economy is just very different to northern Europe. Future Greeks may be very grateful, if the bold step is taken now.

My main point is, Greece should take the decision for the next 50 years, not just the next 5 months.

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Is it a mistake to focus on inflation?

Readers question: should the government focus on achieving a particular macroeconomic objective over the others?

This is a good question. There is a lot that can be said because it encompasses so many different topics.

Firstly, the three main macro-economic objectives:

  • Higher economic growth
  • Low inflation
  • Low unemployment

There are also less important objectives

  • Reducing government borrowing
  • Satisfactory balance of payments
  • Stable exchange rate
  • Protecting the environment

In this post, I will just consider whether  inflation should be seen as the over-riding primary macro-economic objective

Many economists (and Central Bankers) have often stated that low inflation should be the primary macro-economic objective. They argue

  • Low inflation is essential to long term economic prosperity. If inflation is brought under control, then the stability will encourage firms to invest and consumers to spend.
  • If inflation is too high, then it may require lower growth and higher unemployment in the short term. But, this temporary fall in output is worth the long-term benefit of bringing inflation under control.
  • In the long-term there is no conflict – if you keep inflation low, then we will also see strong growth, low unemployment and more competitive exports (helping balance of payments.
  • For example, in 1980, the new Conservative government promised to tackle the high inflation of the 1970s – They used deflationary fiscal and deflationary monetary policy. Inflation did fall, but it caused a severe recession, unemployment rose to 3 million. (In 1981, 365 economists wrote a letter to the Times saying the government should change approach). But, Mrs Thatcher argued she had to stick to the course to rid the economy of inflation.
  • 10 years later, there was another similar experience when the Conservative government again raised interest rates to tackle inflation, leading to another recession. In 1991, the chancellor Norman Lamont wrote

“Rising unemployment and the recession have been the price that we have had to pay to get inflation down. That price is well worth paying.”

– Norman Lamont, Chancellor of the Exchequer. 16th May, 1991 (Hansard) (Unemployment a price worth paying for low inflation)

ECB and their objectives

More controversially, since the credit crisis of 2008, the ECB have appeared to have an over-riding objective to keep inflation low – even though economic growth in Europe has been poor. To many it seems the ECB have been too concerned about low inflation, and have been ignoring other macro-economic objectives, such as economic growth and unemployment. This explains the reluctance of the ECB to pursue quantitative easing (until very recently). It explains why growth in Europe has stalled, and unemployment has increased to 12% – double the rate of the UK and US.

Low inflation as a false goal

 

In this particular circumstance it is arguably a mistake to give undue importance to inflation. Europe desperately needs higher growth, and higher inflation to help

  • Reduce unemployment
  • Avoid the threat of deflation
  • Reduce real debt burdens through increasing cyclical tax revenues
  • Higher inflation would also enable southern Europe countries in the Euro to restore competitiveness without prolonged deflation.

Some economists argue that in the current circumstance of a liquidity trap and stagnant economy, we actually need a higher inflation rate to help improve growth.

Macro-economic objectives depend on the circumstances

There are times, when low inflation could be a desirable goal. If growth is too fast and unsustainable, then using monetary policy to reduce inflation and stabilise the rate of inflation can help to prevent an unnecessary boom and bust.

Low inflation is generally desirable. There are many good reasons to target low inflation in the long term.

However, it is also a mistake to target low inflation and ignore other objectives, which are potentially more important. Arguably the social and political costs of mass unemployment are much greater than a moderate inflation rates. Also, moderate inflation (4-10%) is not good, but also reasonably easy to reduce. The costs of deflation are much higher, and possibly much more difficult to solve.

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Macro Economic Objectives + Conflicts

A look at the possible conflicts between different macro-economic objectives.

The main macro economic objectives are:

  1. Positive and sustainable economic growth (UK, long run trend rate is around 2.5%)
  2. Low inflation (UK target 2% +/-1)
  3. Low unemployment / Full employment (e.g. around 3%)
  4. Satisfactory current account on balance of payments (i.e. avoid big current account deficit)
  5. Low government borrowing
  6. Exchange rate stability

You could also consider:

  1. Issues of equity
  2. Environmental factors (long run environmental sustainability)

Economic Growth vs Inflation

The main conflict can come between economic growth and inflation (which leads to a similar conflict between unemployment and inflation). When the economy expands it is more likely that inflationary pressures will increase. Inflation is particularly likely to occur when growth is above the long run trend rate, and AD increases faster than AS.

Inflationary growth

AD-AS-spare-capacity-Yf

For example, in the late 1980s during the Lawson boom, the UK experienced a high rate of economic growth (4-5% a year). This growth rate was above the long run trend rate of growth and this caused inflationary pressure. When the economy is growing very quickly, firms have difficulty employing sufficient skilled labour; this can lead to wage inflation which leads to higher prices. Also if growth is very quick, there may be supply constraints pushing up commodity price increases.  This economic boom of the 1980s proved unsustainable and ultimately led to the recession in 1991 (as the government increased interest rates to try and control inflation.

The excessive economic growth of 1986-1989 led to inflation increasing to 10%. It required interest rates of 12% and the recession of 1991/92 to bring inflation under control.

However, it is possible to have economic growth without causing inflation. If growth is sustainable – if it is close to the long run trend rate, then LRAS will increase at the same rate as AD, and therefore, we will not see inflation.

Low inflationary growth

inflation
In the UK from 1993-2007, we had our longest period of economic expansion on record. The economic growth did not cause inflation. This is sometimes know as the great moderation.

inflation-growth-90-12

The UK great moderation from 1992 to 2008 – low inflation, positive economic growth.

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Impact of deflationary fiscal policy in UK

A report by NIESR suggests that austerity pursued by the government in 2010, needlessly led to a delayed economic recovery and could have cost the UK 5% of GDP or £1,500 per person.

economic-growth-quarterly

The austerity was unnecessary because

  • The lower growth led to delayed rises in tax increases and
  • Interest rates were at 0%, and demand for government bonds high.
  • By delaying budgetary changes until the recovery was stronger, the government could have avoided a double dip downturn and still be able to reduce debt to GDP in the long term.

The impact of the deflationary fiscal policy could have been worse if:

  • The government had stuck to its initial austerity targets for cutting spending even more over the first Parliament
  • If the Bank of England had not used monetary policy to offset the decline in aggregate demand.

 

“The delay in the UK recovery over the first part of the coalition government’s term is at least in part a result of the government’s fiscal decisions. I have argued that these decisions were a mistake… It will be many years before we can settle on a figure for the total cost of that mistake, but measured against the scale of how much governments can influence the welfare of its citizens in peace time, it is likely to be a large cost.”

Professor Simon Wren-Lewis NIESR

Impact of discretionary fiscal policy

Implied discretionary fiscal change

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