Archive | economics

Problems of Deflation

  • Deflation is defined as a fall in the general price level. It is a negative rate of inflation.
  • It means the value of money increases rather than decreases.
  • Deflation is not necessarily bad, but often periods of deflation / low inflation can lead to economic stagnation and periods of high unemployment. This is because deflation can discourage spending because things will be cheaper in the future. Deflation can also increase real debt burdens – reducing the spending power of firms and consumers.

deflation

In the twentieth century, periods of deflation have been relatively rare. Generally, western economies have experienced inflation. The most significant period of deflation for the UK was in the 1920s and 1930s. These decades (especially, the 1930s) were characterised by economic depression. Prolonged deflation is often considered to be very damaging as it can exacerbate an economic downturn leading to higher unemployment.

Problems of Deflation

  1. Discourages consumer spending. When there are falling prices, this often encourages people to delay purchases because they will be cheaper in the future. In particular, it can discourage consumers from buying luxury goods / non-essential items, e.g. flatscreen TV) because you could save money by waiting for it to be cheaper. Therefore, periods of deflation often lead to lower consumer spending and lower economic growth; (this in turn creates more deflationary pressure in the economy. Certainly this fall in consumer spending was a feature of the Japanese experience of deflation (Japanese financial crisis).
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The price of petrol and tax levels in UK

The UK has one of the highest tax rates on petrol / diesel in Europe – roughly 60% of the final price of petrol goes to the government in excise duty or VAT.

  • UK fuel duty is currently 58p per litre for petrol and diesel
  • VAT accounts for 20-25p per litre
  • The product cost is around 50p per litre
  • firms profit margins is often as low as 5p per litre – even lower for supermarkets, who use petrol as a type of ‘loss leader’ to entice shoppers into the supermarket to spend on groceries.

Between 1993 and 1999, fuel duty rose at 3% above inflation, causing an increase in the price of petrol. However, in 2011, the chancellor introduced a fuel duty stabiliser with a pledge to pledge to keep rates down.

fuel-duty

Source: Fuel duty UK

However, there are economic arguments to suggest that breaking the fuel duty escalator is a mistake. With falling inflation, falling oil prices and rising congestion levels – higher petrol tax could help improve struggling government tax revenues and also contribute to a better environment and lower congestion levels.

Arguments for higher tax on petrol

Environmental costs of petrol. Using petrol causes carbon dioxide (CO2 emissions which contribute to global warming. But, also burning petrol / diesel creates other compounds  toxic to life. For example carbon monoxide and methanol. Also, fine particulates of soot cause from car exhausts cause lung problems and are carcinogenic. Air quality standards in cities would be improved by reducing petrol and diesel consumption. Higher tax would act as an incentive to reduce the pollution caused by driving petrol/ diesel cars (See: tax on negative externality for more on the economics of taxing these negative externalities)

Costs of congestion. Cheaper petrol will cause increased congestion levels. Time wasted in traffic jams is a major individual cost and also cost for business. Without increasing the price of petrol, there will be a rise in the social cost of traffic congestion. The CBI estimate that congestion costs the UK economy £8bn a year. Given the limited scope for increasing the road network in many areas, pricing will have to pay a role – otherwise, we will pay for cheap petrol in other ways.

Improved fuel efficiency and falling tax revenue. One of the benefits of increasing petrol duty in the past has been to increase the incentive for manufacturers and consumers to choose more fuel efficient cars. The consequence is that although petrol tax has risen, the total amount of fuel duty we actually pay is falling – because we are using less fuel. This means government tax revenue from petrol tax is falling. In 2012, the government could expect £38bn from fuel duty and VED. (Link) But, by 2029, this tax revenue could be £13bn lower.

A study by the Institute for Fiscal Studies (IFS) has stated the government face a significant fall in tax revenue from fuel duty and vehicle excise duty (VED). They state that revenue will fall from the current levels of 1.7pc and 0.4pc of GDP respectively, to 1.1pc and 0.1pc by 2029 – in its report Fuel for Thought, commissioned by the RAC Foundation.

Given the poor performance of UK tax revenues in recent years, increasing petrol tax would help meet this deficit. Also, higher petrol tax would further increase the incentive for greater fuel efficiency.

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Saving rates in the UK

It is not a good time to be a saver in the UK. Interest rates are 0.5% and inflation has been above 2% for a high proportion of the previous five years. Because inflation is higher than nominal interest rates, we are seeing negative real interest rates. This means many savers are seeing a decline in the real value of their savings. Pensioners who are relying on interest payments as income, are seeing a decline in their income.

Inflation and interest rates

inflation-base-rates-since-03

In most of the post-war period we have seen positive real interest rates – Base rates above the headline inflation. This means that savers are protected from the effects of inflation.

H0wever, 2008 marks a sharp contrast, with Bank of England base rates falling to 0.5% and inflation reaching above 5%.

In recent months, inflation has fallen to below 2%, but that is still higher than base rates of 0.5%

Effectively, you are getting 0.5% return on your saving, but prices are going up 2%, so the real value of your savings is falling by 1.5%.

Base rates and bank rates

The contrast between base rates and inflation looks very high. But, actually bank savings rates have not fallen as much as base rates. This is because banks were short of money in the credit crunch and were keener to attract deposits than lend money. Therefore, when the Bank of England cut interest rates to 0.5%, commercial banks were not so keen to reduce their own interest rates by as much. Usually commercial bank rates closely follow base rates, but after 2008 we see a break in this correlation.

saving-rates-base-fixed-instant

Source: Bank of England. Series IUMB6VJ | IUMWTFA

In 2008/09, base rates are cut from 5% to 0.5%, but fixed interest rates  (series IUMWTFA) only fall to 2.5 / 3%. Interestingly since mid 2012, fixed interest rates have continued to fall closer to 1%. This suggests the banks are less desperate to attract saving deposits and so can reduce interest rates.

It is a similar story with instant access saving rates (series IUMB6VJ) Since mid 2012, rates have fallen from 1.6% to 0.6%. This suggest the financial sector is in better health, but it means a poorer return for savers.

saving-rates-inflation-since-05

However, if you look around, you can still see higher fixed rates for those willing to ‘lock their money away’

It also depends how much money you can save. For example, according to ‘Money Saving Expert‘ you could get 3.25% if you can put £25,000 away for 5 years. – hardly a great deal, but you would just about get a positive real interest rate.

Should the Bank of England do more for savers?

In the past few years, many groups representing savers have felt they have been ignored – and the government / Bank of England should have done more to give a better rate of return for savers.

However, the past five years have seen declining living standards for most groups of people – real wages have fallen. Unemployment has been very high. The cost of renting has been very high. Given the general economic decline, savers have not been alone in seeing falling living standards. It is complicated by the fact that people with high levels of saving are more likely to be household owners. Homeowners have seen record low mortgage interest payments and rising house prices, which, to some extent, have offset the fall in the return on savings.

Young people without savings, but paying rent, have seen a bigger squeeze on their living standards.

However, someone who is relying on their savings to pay rent, is definitely in a bind.

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Global currency

Readers Question:  Should The World Adopt A Unified Currency?

global-currency

I haven’t given it much thought; given the great difficulties of the Euro single currency within parts of the European Union, the idea of extending this to include even more disparate countries seems a non-starter.

From a philosophic point of view, I think the world is heading towards greater integration, and perhaps in a thousands of years we will global governments, global fiscal transfers and we could move towards a global single currency. But, this would require a completely different mindset of selflessness, breaking down parochial self-interest and seeing the world as one world-family.

Alas, I can’t see this spiritual evolution happening quickly. Some issues to consider in a single currency.

What happens when countries have different inflation rates, but the same currency? In Europe, countries with higher inflation rates (e.g. Greece, Spain, Portugal) were left with large current account deficits, lower exports and lower growth. A global currency, would see even bigger disparities in relative costs and competitiveness.

Single monetary policy. For a single currency to be practical, the assumption would be that you need a single monetary policy. That would be highly impractical and could be devastating for some economies who have different rates of economic growth. For example, we might have very low interest rates, but countries with fast rates of growth could see inflation. It might be more practical to have a single currency, but have regional variations in interest rates. I’m not quite sure how this would work or what the consequences would be. But, with a single global currency you would see a lot of capital flows from less prosperous countries – especially with any variation in interest rate. Continue Reading →

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Price regulation / restrictions

Readers question: Please tell me some products for which equilibrium price is not favourable for some producers and consumers which invite the state to impose price restriction.

The equilibrium price is the price determined in a free market; the price determined by the interaction of supply and demand.

sd

Under what conditions could this market price be unfavourable?

Volatile prices. Some agricultural markets could see very volatile prices due to changes in the weather and inelastic demand. The government could attempt to maintain an average / target price, which avoids these short term fluctuations.

inelastic

For example, a very good harvest could reduce the price of a food item. This low price (p2) would reduce incomes of farmers and could leave them with insufficient money for that year. In this case, the government could use a minimum price (perhaps buying some of the surplus and storing, e.g. see Buffer Stock)

In this case of a minimum price, consumers don’t lose out too much. If price of potatoes falls or rises 20%, it doesn’t make much difference to our living standards, but a fall in income of 20% for farmers could.

On the other hand, if prices rose too much because of a shortage, the government may be concerned that prices were too high and low income consumers might not be able to afford. In this case the government may use a maximum price to prevent prices going too high. The motivation for this is to ensure that all consumers can still afford the good. In developing economies, we may see maximum prices for food, in the developed world perhaps maximum prices for renting or transport. However the problem is that a maximum price may lead to shortages, queues and a black market.

maxprices

Maximum price of Max P leads to shortage D (Q2) greater than Supply (Q1)

Very inelastic supply

If we have a good with a very inelastic supply, it gives firms / owners the potential to increase price significantly. But if the good is very important, the government may again use maximum prices. One example is rents. Supply of rented accommodation is inelastic, at least in short term. Landlords could use this shortage of accommodation to increase the price of rents and make more profit. In the First World War, the UK government introduced it’s first rent controls to prevent landlords increasing rents above a certain amount. The 1915 rent act restricted how much rents could rise during a period of zero house building during the war.

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Economic growth with falling real wages

The UK recovery paints an unusual situation. We have both positive economic growth and falling real wages. How can we have economic growth with falling real wages?

Real wages are not the only source of economic growth. We can see growth from other components of AD –

I (Investment), G (Government spending) plus net exports (X-M)

Also, it is possible for consumer spending to rise despite falling real wages (at least in the short term). For example, if spending is financed by borrowing or declining savings ratio. Consumer spending could also be financed through re mortgaging houses (equity withdrawal) against the backdrop of rising house prices.

Economic growth in the UK

economic-growth-quarterly

Since 2013 Q1, we have seen a decent rate of economic recovery. In the past 12 months – between Q2 2013 and Q2 2014, GDP in volume terms increased by 3.2%

Real wages

uk-real-wages-06-14

Real wages have been falling since the start of the great recession in mid 2008. In a recessing falling real wages are to be expected, but since the recovery, we might have expected real wages to match the growth in real GDP.

Why are real wages falling despite economic growth?

1. Flexible labour markets creating low paid employment. In this recovery, unemployment has fallen more rapidly than previous recessions. Evidence suggests the economy has been successful in creating new employment (often temporary / part-time/ self-employment). These new jobs are not particularly well paid. The recovery is good for job-seekers, but less good for those already in work. The relatively elastic supply of labour willing to take low paid jobs is keeping any wage growth low. Continue Reading →

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UK wage growth

Wage growth is a key factor in determining living standards, aggregate demand and inflation. Since the great recession of 2008, nominal wage growth has fallen behind the headline inflation rate causing a significant drop in real wages.

Research from the ONS, stated that in 2012 real wages have fallen back to 2003 levels. (real wages fall) Between 2010-12, there has been an annual average drop in real pay of nearly 3%. Unfortunately, this trend looks to be continuing in 2014.

Recent wage growth in UK

wages-inflation-07-14

Source: wages KAC3 – ONS (average weekly earnings) – | CPI inflation (D7G7) ONS

Until May 2008, wage growth was above inflation, causing positive real wage growth. But, since 2008, the UK has seen negative real wage growth.

Wage growth since 2000

uk-wages-inflation-01-14

During the great moderation, we saw a steady period of rising real wages. This has been reversed since the prolonged recession of 2008 onwards.

Real wage growth

uk-real-wages-06-14

Economic implications of recent wage trends

1. Muted inflationary potential. Some economists have worried that there is a risk of inflation from ultra low interest rates. During the great depression, we saw cost push inflation, but this has evaporated because they were just temporary factors, such as rising oil prices, higher taxes e.t.c.

This shows the importance of wage growth for determining underlying inflationary trends. Whilst wage growth remains low, there is muted potential for any inflation.

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Economic Growth UK

  • Economic growth measures the change in real GDP (national income adjusted for inflation; ONS call it chained volume measure of GDP)
  • In 2013 – annual GDP in volume terms increased by 1.7% in 2013.
  • In the past 12 months – between Q2 2013 and Q2 2014, GDP in volume terms increased by 3.2%
  • The peak to trough fall of the economic downturn in 2008/2009 is now estimated to be 6.0%
  • In 2013, GDP at market prices was £1,713,302 million (£1.7 trillion)
  • Updated October 6th, 2014

Recent UK Economic Growth

economic-growth-quarterly

Source: ONS IHYQ

Raw data:  National income accounts | real GDP | % change quarterly

Recent history of economic growth

  • Since the recession of 1992 ended, the UK experienced a long period of economic growth – it was the longest period of economic growth on expansion. Also, the growth avoided the inflationary booms of the previous decades. However, the credit crunch of 2007-08 hit the UK economy hard and caused a steeper drop in real GDP than even the great depression of the 1930s. Helped by a loosening of monetary and fiscal policy, the UK experienced a partial recovery in 2010 and 2011. But, by Q1 2012, the UK was back in recession.
  • The second double dip recession was caused by a variety of factors including European recession, lower confidence caused by austerity measures, continued weakness of bank lending and falling real incomes.
  • Since the start of 2013, the UK economy has experienced positive economic growth – one of the relatively best performances in Europe. However, real GDP is still fractionally below it’s pre-crisis peak of 2007.
  • The recovery has been stronger in the service sector than manufacturing and industrial output. There are fears the UK recovery is still unbalanced – relying on government spending, service sector and ultra-loose monetary policy.

It is worth bearing in mind that sometimes economic growth statistics get revised at a later stage.

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Economic impact of welfare freezes

Readers Question: What is the economic impact of proposed welfare benefit freezes proposed by Chancellor, Mr Osborne?

Mr Osborne has proposed a welfare freeze, worth £3 billion of savings over two years. This benefit freeze includes Jobseeker’s Allowance, Income Support, Child Tax Credit and Working Tax Credit, Child Benefit and Employment Support Allowance (paid to those judged capable of work). It does not include pensions, disability benefits and maternity pay.

The Treasury said that about 10 million households would be affected, roughly half of which are working.

The freeze will raise around £1.6bn in 2016/17, rising to around £3.2bn a year in 2017/18.

An argument for freezing welfare benefits is that it will help reduce the budget deficit and also – since 2007, average earnings (+17%) have been rising at a slower rate than working-age benefits (+22%.)

Economic effects

Aggregate Demand (AD) / economic growth. Welfare freezes will (ceteris paribus) reduce consumer spending, and lead to lower aggregate demand. It is an example of deflationary fiscal policy. It will be quite significant because people receiving welfare benefits have a high marginal propensity to consume because, on low incomes, they don’t have the luxury of saving – therefore, lower welfare benefits will directly lead to less spending in the economy.  Welfare freezes will also contribute to a decline in consumer confidence because it will be a visible reminder of economic hardship. Combined with other spending cuts of up to £24bn, there is still scope for these planned spending cuts to derail the economic recovery and cause lower growth or even a future recession.

However, the strength of the recent recovery suggests the UK may be in a better position to absorb austerity than a few years ago. Also, the chancellor can rely on the Bank of England to maintain a very loose monetary policy, which will help to offset the impact of this deflationary fiscal policy.

However, we still don’t know the position of the economy in a couple of years. there is evidence that the recovery still is unbalanced with low productivity growth and low real wage growth making the economy still vulnerable. Continued recession in Europe could  also act as a drag on the UK economy; it is possible that these commitments to spending cuts could hold back economic growth, that even monetary policy can’t overcome.

Deficit reduction. The spending cuts will contribute £3bn to saved spending, helping to reduce the budget deficit. However, it is still a small % of the current budget deficit (£93bn). Also, the reduction in deficit may be less than planned because it will cause a fall in tax revenues (e.g. less VAT receipts from lower spending) and also lower economic growth from the austerity measures.

Some economists argue that deficit reduction is essential and there is no alternative but to cut spending. They hope that cutting the deficit will reassure markets and business about the long-term strength of the economy. Other economists argue that recent evidence suggests people don’t gain confidence from austerity – but actually the opposite. (see: Confidence fairy)

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UK Budget Deficit

  • The budget deficit is the annual amount the government has to borrow to meet the shortfall between current receipts (tax) and government spending. (Forecast for UK 2013/14 is £105bn or 6.5% of GDP)
  • National debt or public sector net debt –  is the total amount the government owes. This is accumulated over many years. See: UK national debt (currently £1,400 bn77% of GDP)

UK Borrowing

  • In 2012/13 net borrowing was £80.7bn (5.2%). (Excluding Royal mail and transfers, net borrowing was £115bn (7.4%)
  • In 2013/14 net borrowing is forecast at £93.7bn (5.7%). Excluding Royal Mail and transfers £105.5bn or 6.5% of GDP
  • Government net borrowing was £121 billion (7.9% of GDP)
  • In 2012/13 public sector net receipts (mostly tax revenue) was £593.5bn
  • Public sector total managed spending was £ 674.2 billion.

UK Net borrowing

uk-net-borrowing-percent-gpd

Latest statistics at OBR

Note this graph excludes sale of Royal Mail which temporarily reduced actual borrowing in 2012-13

net-borrowing-96-12

Figures for 2013-14 onwards are forecasts. Latest statistics at OBR

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