Economics Help » Economics help blog http://www.economicshelp.org Fri, 28 Aug 2015 11:04:48 +0000 en-US hourly 1 What effect do interest rates have on wages http://www.economicshelp.org/blog/14179/economics/what-effect-do-interest-rates-have-on-wages/ http://www.economicshelp.org/blog/14179/economics/what-effect-do-interest-rates-have-on-wages/#comments Tue, 18 Aug 2015 09:55:05 +0000 http://www.economicshelp.org/?p=14179 Readers Question: What effect do interest rates (either a rise, fall or steadying) have on both monetary and real wages? I think I’ve got my head round it, but I’m looking for a nicely explain summary (understanding that there are probably a million of contributing factors that can lead to a million outcomes!)

You are right, there is no direct link between interest rates and wages (either nominal or real), and there are thousands of possible combinations, which make it difficult to create simplistic answers. But, interest rates can have an impact on wages through affecting the rate of economic growth and inflation.

Interest rates and economic growth

Higher interest rates increase the cost of borrowing, so firms will cut back on investment and consumers will cut back on spending. This could lead to lower economic growth. With less demand and higher interest payments, firms may seek to cut wages (or increase wages at slower rate)

Furthermore, if higher interest rates do have the desired effect of reducing the rate of economic growth, then as well as lower economic growth, we should get lower inflation. This will be another factor leading to lower nominal wage growth.

 

Fall in AD.

fall-ad-full-capacity

In this case, higher interest rates have reduced AD, leading to lower inflation and lower economic growth.

With lower inflation, we would expect to see lower nominal wages. But, also real wages (nominal – inflation) may be less affected.

  • Suppose inflation is running at 4% and nominal wage growth is running at 6%. (real wages = 2% growth)
  • Higher interest rates may reduce inflation to 2% and nominal wage growth falls to 4%. (but, real wage stay at 2%)

In this case higher interest rates have reduced nominal wage growth, but left real wages unchanged.

However, if the higher interest rates caused a serious fall in real GDP, then there may be a significant fall in nominal wages, with only small fall in inflation. Therefore, in this case, higher interest rates could cause a fall in real wages.

fall-in-ad

If higher interest rates caused a fall in AD from AD3 to AD4, then there is a big fall in real GDP from Y3 to Y4. This could lead to a fall in both nominal and real wages.

Sticky wages downwards

There are so many other variables which make it difficult to predict.

If we get a fall in AD, firms may cut back on output. However, workers may resist nominal wage cuts – wages are often said to be ‘sticky downwards’. Therefore, wages may fall less than we might expect. It could lead to real wage unemployment.

Real wages in great recession

uk-real-wages-06-14

Usually, a cut in interest rates would be expected to increase aggregate demand (AD) – leading to higher economic growth and a rise in nominal wages.

inflation-base-rates-since-03

However, when interest rates were cut to 0.5% in 2009, growth was still very sluggish. We were in a liquidity trap – lower interest rates didn’t boost spending. Growth remained negative or weak. Due to flexible labour markets Nominal wage growth remained very low.

In the great recession, we also saw periods of cost-push inflation. Therefore, we often had periods of negative real wage growth. Inflation was higher than nominal wage growth.

So in this case, cutting interest rates didn’t cause a rise in nominal or real wages. In fact, this period led to negative real wages. But, this was because the nature of the recession was very severe. The normal relationship between interest rates and economic variables broke down.

There are numerous other possibilities we could look at.

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New OCR economics revision guide http://www.economicshelp.org/blog/14164/revision/new-ocr-economics-revision-guide/ http://www.economicshelp.org/blog/14164/revision/new-ocr-economics-revision-guide/#comments Tue, 11 Aug 2015 07:43:24 +0000 http://www.economicshelp.org/?p=14164 ocr-revision-guideI have spent past few weeks working on the new OCR A Level in economics revision guide. (H460)

First teaching from Sept 2015. First A level exam Summer 2017.

On the positive side, the syllabus is very detailed. OCR are very clear on what you need to cover.

After doing AQA and Edexcel revision guides, I thought (perhaps hoped!) that OCR would be quite quick. It wasn’t. The OCR syllabus did seem to go on for a long time! Part of this is the detail of the syllabus, part of this is due to an element of repetition. But, OCR economics also includes concepts not required in any other exam board. For example, in macro economics, knowledge is needed of:

  • Liquidity preference theory
  • Loanable funds theory
  • Heckscher-Ohlin theory of trade
  • Austrian economics
  • Symmetric inflation targets
  • Asymmetric inflation targets
  • Kuznets environmental curve
  • Genuine progress indicator (GPI)

It’s only a very minor complaint. I don’t think it will affect students. But, I was hopeful that Ofqual would try ensure greater compatibility between exam boards.

It is available as single user license. (£9.50) Also, available as network license £95.00 – allowing unlimited use for an educational establishment

It’s been a long summer, but here it is OCR Revision guide

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TIPP – UK / US trade deal http://www.economicshelp.org/blog/14145/trade/tipp-uk-us-trade-deal/ http://www.economicshelp.org/blog/14145/trade/tipp-uk-us-trade-deal/#comments Thu, 06 Aug 2015 09:59:12 +0000 http://www.economicshelp.org/?p=14145 TIPP (Transatlantic Trade and Investment Partnership) is a potential trade deal between the EU and US. It is currently being negotiated by the European Commission and the US.

freightliner-railway-train

The aim of the agreement is

  • Encouraging trade and investment between the EU and the US.
  • Extend principles of European Single Market to include the US, enabling lower prices for consumers, greater trade and prosperity.

However, critics of the agreement fear that the proposal will lead to lower environmental standards, job losses, privatisation of public services, and overall is geared towards favouring big business at the expense of the consumer and environment.

The main areas of TTIP include

  • Removal of red tape and bureaucracy for firms who are exporting.
  • Setting new rules to make it easier to export, import and invest.
  • Harmonisation of rules and regulations relating to trade between EU and US.
  • Create a fairer process and clearer rules for firms who invest in other countries. This includes ISDS (Investors state dispute settlement) which enable firms to sue governments for lost profits relating to government regulation.

Potential benefits of TTIP

  • Encouraging inward investment from US companies, which will lead to the creation of jobs and kickstart the EU economy.
  • Extending the principles of the single market to reduce interference and non-tariff barriers to trade
  • Greater choice of imports, enables lower prices for consumers. This could be significant in areas like jeans and cars. It might help to reduce the price differential between US and EU in areas like clothes and computers.
  • More exports. The UK could export more to US. For example, British lamb and venison cannot currently be exported to US.
  • The EU received over €325 bn investment flows from around the world (34% of world inward investment) The British government have claimed that TTIP could add £10bn to the UK economy.

Criticisms of TTIP

  • Unaccountability of TTIP negotiations. With negotiations occurring behind closed doors, many fear that important decisions on trade and the environment are being made by unelected and powerful business interests.
    • However, it will still be up to the EU and national governments to accept or reject any treaty. Critics may argue that because of potential benefits, the agreement will be supported – even if it contains areas which are highly damaging. The UK government has already publically supported TTIP and are likely to accept any agreement.
  • Investor state dispute settlement (ISDS) A key US demand in negotiations, this allows private firms to sue government for loss of profits related to regulation. Examples, including US fracking company suing the Quebec government following a ban on drilling under St Lawrence River. The ISDS would be enforced by an independent body, which would bypass national courts. It could potentially be damaging if US company sue for loss of profits, due to a government wishing to protect environment. The fear is that TTIP could be weighted towards interests of powerful companies more than consumers and environment.
    • However, it is worth bearing in mind, there are already many of these agreements in place, in theory ISDS could help improve the balance between business and local society.
  • Access to cheap fossil rules. The TTIP could allow Europe access to cheaper US crude oil and natural gas. This would lead to lower energy prices for consumers.
    • However, it would damage the EU’s renewable energy industry and damage efforts to reduce reliance on fossil fuels.On the other hand reduced regulations over wind farms could enable growth and lower costs in this industry.
  • Structural unemployment. Trade agreements often lead to winners and losers. In the short term, some EU companies will lose out to cheaper and more efficient US firms. This can lead to structural unemployment in Europe.
    • On the other hand, the TTIP can open up markets for EU exporters. Overall the increase in competitive pressures from the trade deal may encourage greater efficiency amongst firms.
  • Privatisation of public services. One of the potential aims of TTIP is to open up public services, such as health and education to US companies, increasing competition and potentially reducing costs. But, there are fears this will accelerate process of privatisation of important public services, leading to a decline in standards.
    • The EU commission counter by saying that EU governments will still be able to retain a monopoly in public services, provide subsidy and limit access to those markets if they wish. EU commission on TTIP
  • Removal of local content requirements. Currently renewable energy needs to be sourced locally. Removing this requirement enables energy firms to import renewable energy. This can improve the renewable energy market, but it could be unpopular locally as people are less likely to support wind farms if the energy is exported to other countries.
  • Harmonisation of regulations could lead to lower standards. US has different regulations on foods. For example, it has greater tolerance of pesticides and GM foods. If the EU harmonises legislation to US standards, it could lead to a decline in standards on food, chemicals and the environment. For example, the EU currently bans 1,200 substances from cosmetics, the US just 12 (due to precautionary principle). The other fear is that with common regulations, they could be pressure to cut regulations and impose lighter targets on issues such as carbon emissions.
    • On the other hand, harmonisation could lead the other way. The EU could adopt stricter regulation on finance, and the US could adopt stricter legislation on the environment. However, increased regulation may be hard to sell due to opposition from companies who would have higher costs.

 

  • Protection of standards. The EU claim that the TTIP will protect key regulations and public services. They state that the TTIP will not compromise
    • EU standards.
    • The precautionary principle for avoid potential problems to environment / society.
    • Giving EU countries the right to not accept any commitment to open up public services to other providers. EU commission

Conclusion

In theory, a trade deal between the US and EU makes sense. It has the potential to create a larger trading block and remove unnecessary blocks on trade and investment. Harmonisation of rules and regulations could help promote greater co-operation – a co-operation which is needed to solve a global problem like environmental degradation.

However, it all depends on the content of the TTIP. It could be an opportunity to lower EU environmental and labour standards and encourage a race to the bottom in terms of government regulation.

The other fear is that the general agreement may have significant benefits in terms of trade, but within the agreement contain several sections which are undesirable and regressive in terms of supporting the environment / public services. In order to get the larger benefits, we may be stuck with smaller issues which are undesirable.

Related pages

External pages

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What has borrowing ever done for me? http://www.economicshelp.org/blog/14122/uk-economy/what-has-borrowing-ever-done-for-me/ http://www.economicshelp.org/blog/14122/uk-economy/what-has-borrowing-ever-done-for-me/#comments Thu, 23 Jul 2015 07:46:23 +0000 http://www.economicshelp.org/?p=14122 A reader on twitter asked – How has government borrowing helped me recently?

I’m tempted to paraphrase as – What has borrowing ever done for me? – just so that I can make a reference to Monty Python and the Life of Brian? – And what have the Romans ever done for us? – apart from education, sewers, wine, roads, peace, law and order  … (youtube)

I’ve answered this question several times before:

But, I frequently get asked it, so here’s a few more ideas.

Why do we need to be in debt at all?
Surely all the money in interest (some £50bn pa?) would be better spent on ourselves as a country?

It is true that the government spends around £50bn a year on interest payments. (and forecast to rise) But, those interest payments enable higher government spending now.

We could reduce the amount of interest payments by raising taxes / cutting spending. But, it wouldn’t make us better off. It would just change how we finance current spending.

Also, who do those interest payments go to – primarily UK individuals/UK pension funds. You can think of it as a transfer payment to people within a country.

You could argue that it is a transfer payment from the average taxpayer to people with pension funds / city financiers – who are likely to be better off. But, more people with private pensions may benefit from government interest payments than they realise.

Interest rates are also very low, which means interest payments on government debt are quite a small percentage of GDP. (3%)

Use of private sector saving

In the great recession, there was a rapid rise in private sector saving. This was money not used, but just saved and unproductive.

net-lending-private-public-debt

Source: ONS

If the government borrowed nothing, these resources would remain idle, aggregate demand would be lower and the recession deeper. Through government borrowing, we made use of this surplus savings and helped to stabilise the economy. (recession not as deep)

Borrow in recession

A firm will often have to borrow in a recession, because of a temporary fall in revenue leads to temporary loss of profitability. It is the same for the government. In a recession, tax revenues fall and benefit spending rises – and these automatic fiscal stabilisers help to prevent the economy sliding deeper into recession.

Alternative of no government borrowing

Suppose we had a fiscal rule that the government is not allowed to borrow? What would have happened in the great recession?

As the recession hit, the government would have to slash spending and raise taxes. But, in a recession, cutting spending and raising taxes would make the recession worse. It would cause a rise in unemployment and further reduce tax revenues.

Greece has been trying for several years to reduce debt by increasing taxes and cutting spending. But, the negative effect on the economy is so deep, that the austerity is proving to be self-defeating.

 

Future generations

I often hear that government borrowing is unfair on future generations. But, are we disadvantaged because past governments in the 1950s and 60s, borrowed money? No. It might have been much worse, if they had insisted on reducing debt and not investing in building roads and education.

Source: A view of UK public spending

Debt interest payments as a % of GDP are fairly stable at 2-3% of GDP.

Is borrowing really bad?

Another way of thinking about it is does a firm ever borrow? Does a household ever borrow?

If a homeowner wanted to stop paying mortgage payments on debt, they could sell house and rent instead, but it doesn’t make them better off.

A firm often borrrows to invest for the future. The aim of most firms is not to have no interest payment, but to increase capacity for future expansion.

It is the same with the government. The UK has failings in transport, education and health care. Higher government spending could lead to improved infrastructure, which helps economic growth in the long-run. If we borrow to finance this investment, then we are getting a better rate of return than the cost of interest payments – which are currently low.

You could argue that a government is different to a firm. A government spending is liable to government failure – a higher risk of inefficiency and wasted spending. But, a government can also help to tackle inequality and deal with market failure.

Does that not mean that running a surplus would eventually get us out of the red and into the black? I understand that this is a naive way of looking at the economy, but surely long term this would be achievable. Why 

Running a surplus would eventually reduce national debt. But, would it be advisable for the government to run up savings and hold on to money that could be better used in the economy?

uk-national-debt

Also, even if you run a persistent budget deficit, you can still reduce the ratio of debt to GDP. In 1950, debt to GDP was close to 200% of GDP. This fell to 40% of GDP by 2007 – yet we nearly always had budget deficits in this period (1945-02007). The reason is that if growth is higher than government borrowing, the proportion of debt falls. This is what happened?

What did borrowing ever do for us?

  • It enabled the post-war economic expansion of 1950s and 1960s.
  • It enables investment in countries infrastructure
  • It can prevent a great depression style collapse in the economy.

Related

 

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Is it so bad to leave the Euro? http://www.economicshelp.org/blog/14090/debt/is-it-so-bad-to-leave-the-euro/ http://www.economicshelp.org/blog/14090/debt/is-it-so-bad-to-leave-the-euro/#comments Mon, 13 Jul 2015 06:29:05 +0000 http://www.economicshelp.org/?p=14090 Leaving the Euro is supposed to be irreversible.

If a country did threaten to leave the Euro – it was argued it would lead to bank runs, loss of confidence, high unemployment and a serious recession.

But, what if you already have all of these components?

The Greek economy is in dire state. Furthermore, their main creditors are behaving with tremendous short-sightedness, ignorance or either vindictiveness. This is trying to put it politely.

Given how disastrously unsuitable the Greek economy has been in the Eurozone straight-jacket, now is the opportunity to take back economic and political freedom.

It’s not just about money. But, the latest demands of the troika should be impossible for any democratic government to accept.

New currency / devaluation is a possible new start

The fears of leaving the Euro and gaining a new currency are not without foundation. It will be very difficult, especially for a couple of years. But, countries do recover from devaluation. Countries do even recover from hyperinflation.

But, I’m not sure countries can recover from years / decades of austerity and giving all their economic sovereignty over to a foreign power.

 

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A short note on Greece http://www.economicshelp.org/blog/14080/economics/a-short-note-on-greece/ http://www.economicshelp.org/blog/14080/economics/a-short-note-on-greece/#comments Mon, 06 Jul 2015 09:07:04 +0000 http://www.economicshelp.org/?p=14080 Just a short note on Greece because at the moment I’m concentrating on writing revision guides.

For several years I have felt that Greece would be better off to leave the Eurozone. This is partly due to economics, but also partly an intuition – that there is no greater recipe for political disaster than having disastrous economic policies dictated by a foreign power (EU, IMF, Germany)

The frustration in Greece at Europe is well-merited.

  • Leaving the Eurozone will perhaps make Greece masters of their own destiny. They will not feel they are under the thumb of Europe (aka Germany)
  • Leaving the Eurozone gives the possibility of a better long-term framework – which doesn’t involve common monetary policy, exchange rate and fiscal austerity.
  • Staying in the Eurozone offers only an endless diet of self-defeating austerity is a recipe for deep frustration – it is hard to see any hope.

I’m conscious of the fact I that the consequences of default and Euro exit will be equally damaging – if not more so in the short/medium term. I’m also conscious of the fact – I’m not quite sure what will happen. There are not many precedents of developed economies going through such difficult times. There is the very strong likelihood of it being very grim for a considerable time. But, it should be remembered you can always come out of the worst crisis. Germany’s own hyper inflation was devastating for a couple of years. But, it did recovery.

Failure for Europe

The Greek crisis is not just a failing for the Euro project, but the whole European idea. European politicians will want to blame the irresponsible Greeks who had the temerity to ask the population what they thought, but it reminds you of the story about the plank in your own eye.

The incomprehensible desire for never-ending austerity has been wholly self-defeating for both Greece and the Greek creditors.

Time to rescue Greece

Whatever happens, there needs to be a swallowing of pride and a real European willingness to support Greece in this crisis period. A failed Greek economy should be seen as a failure for the whole of Europe.

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New AS Economics – Edexcel revision guide http://www.economicshelp.org/blog/14067/economics/new-as-economics-edexcel-revision-guide/ http://www.economicshelp.org/blog/14067/economics/new-as-economics-edexcel-revision-guide/#comments Wed, 01 Jul 2015 09:54:17 +0000 http://www.economicshelp.org/?p=14067 Edexcel-AS-Revision-GuideI have just finished the new version of AS Edexcl economics revision guide. It is updated for the new syllabus, which will be used for first exam in 2016.

The Edexcel AS revision guide is 108 pages, 20,800 words.

More details here: AS Edexcel Revision Guide £5.00

Network license for schools

For schools, I am making available as a network license allowing unlimited use, with word doc.

Coming soon

I will be finishing A2 revision guide.

I will soon be bringing out revision guides for AQA, OCR, Welsh board and Cambridge International

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Effects of a budget surplus http://www.economicshelp.org/blog/14011/debt/effects-of-a-budget-surplus/ http://www.economicshelp.org/blog/14011/debt/effects-of-a-budget-surplus/#comments Sat, 13 Jun 2015 07:18:10 +0000 http://www.economicshelp.org/?p=14011 The chancellor George Osborne has recently announced a plan to enshrine budget surpluses in law. It is worth noting, that budget surpluses are quite rare in the past 120 years.

net-borrowing-96-12

The argument of the chancellor is that with national debt ‘unsustainably high’ – periods of economic growth should be taken as an opportunity to pay down debt and reduce the burden for future generations.

What is the impact of a budget surplus?

1. Higher taxes / lower spending. To ensure a budget surplus, the government will have to cut spending and / or increase taxes. This could happen more than the government may like; there are certain long-term factors which work against the government’s fiscal position, such as the demographics of an ageing population. Also many tax revenue sources have been falling, (e.g. decline in use of petrol)

2. Impact on growth. If the government is forced to increase taxes / cut spending to meet a budget surplus, it could have an adverse effect on the rate of economic growth. If government spending is cut, then it will negatively affect AD and could lead to lower growth.

A budget surplus doesn’t have to cause lower growth. If the economy is booming, then a budget surplus could be compatible with strong economic growth. Also, even if the government increase taxes, the Bank of England could ease monetary policy to maintain strong growth. In fact, in a booming economy, Keynesian economics suggest that a budget surplus could help prevent excess growth and inflation.

The concern is that the government will be forced into creating a budget surplus when growth is positive, but not strong enough to absorb the deflationary fiscal policy (higher T, lower G). For example, with interest rates already at 0.5%, there is limited scope for the Bank of England to ease monetary policy further. The UK recovery is more fragile and unbalanced than we would like – it is arguably not strong enough to absorb austerity – and it is difficult to predict when it will. Targeting a budget surplus, we may still experience economic growth, but the austerity and fiscal tightening means that the economy runs below full potential and leads to higher unemployment than otherwise.

3. Impact on household debt. Austerity has a strong political appeal, because there is dislike of the idea of debt. But, a government budget surplus could ironically lead to higher household debt. In the financial crisis, household debt as % of GDP fell as consumers / firms tried to pay off debt. This led to fall in spending, which was partly offset by rise in government borrowing. However, with the ongoing real wage squeeze, the OBR predict a rise in household debt in the next five years.

  • In 2008, household debt was 169% of GDP. This has fallen to 135% of GDP. However, the OBR says by 2019 this will rise to more than 173%. (Guardian)

If the government pursue tight fiscal policy – higher taxes, lower spending cuts, this will squeeze household disposable income and they may have to respond by increasing debt levels. A budget surplus takes money from elsewhere in the economy. It doesn’t create money.

4. Impact on cost of borrowing. One argument for running a budget surplus is that it will reduce levels of national debt, and push down bond yields and reduce the amount of debt interest payments future generations pay. This will make it cheaper for the government to borrow. UK debt interest payments are already set to rise.

uk-debt-interest-payments-total

Interest payments on UK debt

However, as a % of GDP, debt interest payments have been more stable.

uk-debt-interest-payments

Also, bond yields in the UK are already very low. so running a budget surplus may have little impact on reducing bond yields. Though others may argue that without cutting deficit now, bond yields will rise in the future.

5. Impact on ability to survive future problems.

One argument for running budget surpluses is that it gives you more scope for meeting a future crisis. If you meet a future crisis with debt at 100% of GDP, it may be difficult to pursue expansionary fiscal policy. If debt has fallen to 50% of GDP, there is less need to panic.

However, if budget surpluses reduce the rate of economic growth, then this will damage the long-term potential of the economy. It is worth bearing in mind, that the UK began the 1950s with national debt at 200% of GDP, but it was no barrier to a golden age of economic prosperity and rising living standards. National debt doesn’t have to saddle future generations with poor prospects.

6. Impact on investment

If the government is committed to running a budget surplus, it is likely the government will need to cut back on public sector investment. – Investing in railways, roads, housing, communication, education, skills, training. These are all areas where this market failure. Private firms will not build new roads or fix potholes because they are effectively public goods. If the government cut back on investment, it could harm the long-term productive capacity of the economy.

Some feel the idea of government borrowing is very wrong. But, it should be remembered successful firms borrow for investment, households borrow to fund a mortgage. The economy can benefit from public sector investment. The rate of return on public sector works can be significantly higher than the current borrowing costs.

The real problem in the UK economy is not budget deficit, but poor productivity growth. The government can play a role in increasing productivity through investing in vocational training and dealing with transport bottlenecks. But, if the highest priority of the government is running a budget surplus, there will be limited resources to fund this.

7. Is national debt actually unsustainable?

It is much repeated that UK national debt is unsustainable, but is this actually true? For example, demographic trends will place increased pressure on government social security and NHS. These transfer payments are seen as unsustainable because it is not borrowing for investment. This is an important concern.

But, if UK debt is unsustainable – why are markets so keen to buy debt? Bond yields are very low, indicating that private firms don’t need a high interest rates to compensate for any perceived risk.

uk-national-debt

I often publish this graph to put UK debt levels into perspective. It is true that some circumstances were different in the 1950s. But, levels of debt are by no means unprecedented.

8. You don’t need a budget surplus to reduce debt to GDP ratio

borrowing-percent-gdp-69-14

The UK very rarely had a budget surplus 1950- 2013, but will still reduced debt to GDP ratio quite a lot – because economic growth reduces debt to GDP.

Conclusion

When growth is strong, it makes sense to improve the nations finances and reduce debt as a % of GDP. The counterpoint of expansionary fiscal policy in a recession, is that there need to be automatic stabilisers the other way.

However, the concern is that making budget surpluses a top economic priority could mean we take decisions which are not in the best interest of the economy. The value of budget surpluses is not that great, but they do come at an opportunity cost of taking money from elsewhere in the economy.

Governments and Central Banks need greater flexibility and not to be tied down with fiscal rules (which have proved so damaging in Eurozone)

Also, there is a very strong case for governments borrowing to finance public sector investment. We need investment in training, housing and transport to help long-term economic growth. It would be very short-sighted to target fiscal goals.

 

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Can Labour be blamed for the economic crisis? http://www.economicshelp.org/blog/14006/economics/can-labour-be-blamed-for-the-economic-crisis/ http://www.economicshelp.org/blog/14006/economics/can-labour-be-blamed-for-the-economic-crisis/#comments Fri, 12 Jun 2015 08:54:42 +0000 http://www.economicshelp.org/?p=14006 Readers Question 1. Can Labour be blamed for the economic crisis (i.e. did they really ‘overspend’)?  My view is that the global economic crisis is to blame, and that Labour could have spent less but that this is easy to say with the benefit of hindsight.

I don’t think there is any economist who would try to blame the global financial crisis and global recession on the fact the Labour government increased spending on the NHS / education by a relatively moderate amount.

The global recession of 2008-13 was caused by the great financial crisis / credit crunch. The cause of this lay in several factors, but was primarily due to:

  • Excess mortgage lending, especially in US
  • Housing markets experiencing boom in prices that was unsustainable
  • Banks around the world taking risk with purchase of risky sub-prime mortgage debt, rebundled debt – leading ultimately to credit crisis.

This is only a very brief summary because I have written on this in more detail previously. But, it was essentially a failure of the financial sector.

It is true real government spending under Labour increased significantly. (see more detail at: Government spending under Labour)

UK-government-spending

But, as a percentage of GDP, the rise is far less significant – at least until the recession (2008-09) when GDP fell 6%. (causing spending/GDP to rise)

g-spending-percent-gpd-96-14

Was it a mistake to run a budget deficit during the boom years of 2000-07

uk-net-borrowing-percent-gpd

I would say it was a small mistake to run a budget deficit of 3% of GDP during the boom years. From a Keynesian perspective it would have been more desirable to have run close to a balanced budget.

However, it is also worth mentioning

  • I don’t think a balanced budget would have done anything to prevent a recession. The recession would still have occurred with the same impact, even with a balanced budget. This is because the global recession had nothing to do with UK government spending / government borrowing.
  • I don’t believe governments have to run a budget surplus during boom years. Borrowing to fund investment in improving long-term infrastructure can reap long-term benefits. (I will write more on this in the future)

Tax receipts based on boom economics. One criticism about the UK finances (like many other countries) in the 2000s was that UK tax revenues were quite reliant on a booming financial and housing sector. When the financial market fell, tax receipts were very hit hard (and have struggled to recover). In other words, the UK fiscal position was not as good as it looked.

Borrowing and room for manoeuvre

One argument is that if the UK had run a balanced budget in the 2000s, public sector debt would have been lower and the UK would have had more room for manoeuvre in pursuing expansionary fiscal policy when the recession hit and we needed expansionary fiscal policy.

There is some credence to this, with a balanced budget and lower public sector debt to start with, governments may have felt greater confidence to borrow even more in the recession – when the UK economy needed expansionary fiscal policy.

However, it is also worth being sceptical. Public finances in the UK were very good in 2007; by comparison with the past 100 years, we were near a record low.

uk-national-debt
Spot the economic mismanagement of the Labour government 1997-2007.

 

The UK did have room for expansionary fiscal policy in 2008, bond yields were falling – there was never any fiscal crisis in the UK.

The lurch to austerity post 2010, was unnecessary driven more by Micawber economics and the strong political appeal of austerity. My feeling is that even if the UK had run a balanced budget in 2000-07, there would still be the same strong calls for austerity. People who think £180bn is ‘too much borrowing’ – would probably think – £80bn borrowing is too much as well.

The real economic mistakes of pre crisis period

The real mistakes of the pre-global recession period were not government spending or government borrowing (which were both pretty good by post war standards). The missed opportunities were:

  • Failure to regulate financial system. The 1980s saw a period of financial deregulation, building societies became profit oriented banks willing to take extravagant risks (e.g. Northern Rock, Bradford & Bingley) In the US mortgage companies behaved with complete irresponsibility. The lax controls on mortgages and bank ratios was a great mistake.
  • Failure to build up a bank bailout fund. In the boom years, it would have been a good policy to make banks pay into a fund for their potential future bailout should the market turn. This would have curtailed some of the banks risky expansion and meant that there was a government fund to use to bailout banks – rather than just relying on general tax payers money.
  • Housing market. The boom and bust in the US and European housing markets was a significant issue.
  • The Euro. The Euro is a deeply flawed economic policy, which has very strong deflationary bias. The pre-crisis period saw massive imbalances in the Eurozone area with countries in the south running current account deficits running into 10-12% of GDP. Without currency fluctuations, without a lender of last resort – in retrospect, this was a disaster waiting to happen.
  • Greek debt. The one country with a real debt problem was actually Greece. Other European countries, such as Ireland, Spain and Portugal had very low levels of government borrowing at the start of the crisis, but were forced into a debt crisis through the mechanism of the Euro.

Was anyone calling for regulation of banks / mortgages / housing market?

To be fair to Labour, they were not alone in ignoring the shadowy world of financial markets – just about everyone, including the majority of economists, didn’t realise what a hidden problem the financial markets were.

For example, I don’t think even the most ardent Conservative supporter would claim that the Conservatives would have taken on the banks and prevented the financial crisis.

Conclusion

On a personal note, I’ve found it quite difficult how it has become accepted conventional wisdom that somehow Labour economic mismanagement was responsible for the great recession. It is a bit worrying how the banks have got off very lightly with the blame rather disingenuously put onto this vague idea of Labour economic mismanagement.

Related

 

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New economics AS and A2 syllabus http://www.economicshelp.org/blog/14000/economics/new-economics-as-and-a2-syllabus/ http://www.economicshelp.org/blog/14000/economics/new-economics-as-and-a2-syllabus/#comments Thu, 11 Jun 2015 07:10:26 +0000 http://www.economicshelp.org/?p=14000 Revision-Guide-AS-A2There has been an update to the economic syllabus for those taking A2 exams in 2017.

It means that students starting to study Economics AS in Sept 2015, will be doing the new syllabus, with first AS exams in June 2016, and the first A2 exams in June 2017.

Students who have already started economics AS this year, will be unaffected and they will continue with the existing syllabus.

Major changes

  • AS and A2 will be linear. AS exams will not count towards final A2 result

New topics

  • Global financial crisis
  • Behavioural economics

New economics revision guide

I am currently updating all my economics revision guides. I have started with Edexcel and will move on to the other exam boards soon.

It is more of an evolution than radical change, but it is one thing I like about economics – the syllabus does naturally evolve. Core principles stay the same, but application to the real world does change.

I will be selling AS and A2 revision guides separately in the future, and will make available institute wide licenses for unlimited use in particular schools.

New Economics syllabus

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