Comparing UK and US Recessions of 2009-11

What explains the difference between UK and US economic growth rates since the start of the crisis in late 2007? Firstly, the recession was slightly deeper in the UK with a 6% fall in real GDP during 2008.  Possibly, the recession was deeper in the UK because of our greater reliance on the financial sector. Since …

Read more

Unlimited ECB Bond Purchases

Ever since the Euro debt crisis hit the headlines in 2008, economists have argued that the ECB need to act and buy bonds to prevent liquidity fears and prevent bond yields from being artificially high. Held back by fears of the ECB exceeding their mandate, we have watched in despair, as bond yields on Eurozone …

Read more

Would Devaluation Help Greece?

Readers Question: Would a devaluation help Greece?

If you look at the Greek economy, their exchange rate has been effectively overvalued for several years. This overvalued exchange rate has caused Greek exports to be relatively uncompetitive and has caused various economics problems. Combined with efforts to tackle an unsustainable debt level, the over-valuation has contributed to prolonged recession.

Impact of Over-valued Exchange Rate

  • Very high current account deficit (over 10% of GDP)

greece

  • Falling GDP – output shrinking since 2008.
  • High unemployment close to 50%

If Greece was in a floating exchange rate, there is no doubt that their currency would have fallen rebalancing domestic demand and improving economic growth. (see: why Greece would devalue)

If Greece was in a semi fixed exchange rate (such as the old ERM), there is no doubt that they would have reduced the currency peg and devalued the currency.

The problem is that in the Euro, the only option to devalue is to leave the Euro 0 with all the economic uncertainty that leaving the Euro would entail.

For Greece, the choice has always been between the benefits of devaluing and regaining independent monetary policy vs the cost of leaving the Euro and experiencing the capital flight and uncertainty this would entail.

Summary of Greek Devaluation

Advantages

In theory, a devaluation would help increase Greek domestic demand and enable an economic recovery.

  • Imports would be more expensive causing demand for imports to fall – instead people would buy more domestic goods.
  • Greek exports (and tourism) would become more competitive. Therefore, demand for exports and tourism would rise. A substantial devaluation of 50-70% could create many long-term opportunities to develop new export industries and encourage more tourism.
  • This boost to domestic demand would also help create jobs and tackle Greece’s dire unemployment.
  • Without devaluation, Greece could face years of depression as they are unable to create any boost to domestic demand in the current situation.
  • The current policies of austerity have failed to  tackle the deficit, but have pushed the economy into a very dangerous deflationary spiral with levels of unemployment which threaten the social fabric of the country.

Problems of Devaluation

  • A devaluation of 50% would cause a jump in inflation as imported goods go up. This could cause inflation of up to 50%.
  • Inflation of 50% will increase the costs of living and reduce living standards.
  • Devaluation involves leaving the Euro. Therefore there is a risk of substantial capital flight as Greek savers try to protect the value of their savings by moving into Euro bank accounts rather than lose value. This capital flight would cause banks to run out of liquidity. There would need to be government backed support for banks.
  • The devaluation would increase the effective debt to GDP ratio. It could see Greece’s national debt rise to over 200% of GDP. Therefore, there would need to be a substantial default because outside the Euro, bailout funds would dry up.

Overall

Exit would be very painful and difficult. But, staying in the Euro, only seems to be prolonging the economic pain Greece is facing. If Greece did devalue and leave the Euro, they would at least be in a position to avoid the current situation of trying to manage in a single currency which doesn’t work for them.

Read more

Balanced Budget Fiscal Expansion

Balanced Budget Fiscal Expansion is an attempt to increase aggregate demand through changing spending and taxation levels, whilst leaving the overall fiscal budget situation the same.

Essentially, the idea is that if you increase spending and taxes equally, the increased government spending has a bigger positive impact on economic growth than the negative impact of higher taxes.

A key factor in balanced budget fiscal expansion is the idea of the multiplier effect. Through the multiplier effect, higher government spending on capital projects may cause a bigger final increase in real GDP. (e.g. with a multiplier effect of 1.5 –  £1bn of government spending, may increase real GDP by £1.5bn) Therefore, by financing capital investment through higher taxes we can, in theory, increase economic growth without increasing the budget deficit.

To explain the idea of balanced budget fiscal expansion it is best to use examples. Two ideas spring to mind.

1. Reduce spending on pensions, increase spending on capital investment.

If the government increased the retirement age it would reduce government spending on pensions. The  money saved can be used to finance higher capital investment. Overall government spending remains unchanged, but people are working longer, and the government can finance capital investment which can increase aggregate demand.

2. Increase Income Tax for a temporary period and use the money to finance capital investment.

The social market foundation recently proposed bringing forward £15bn of tax increases and using this to spend on infrastructure spending. (PDF)

If income tax were increased for a short period, say three years, people would tend to spend less, therefore there would be a fall in consumer spending. However, the government could use the money raised to finance capital investment. For example, building schools, building roads or a new airport in London. Therefore government spending will increase and offset the fall in consumer spending.

If there is no multiplier effect, the fall in consumer spending will be equally offset by a rise in government spending. Economic growth and the budget will be unchanged.

However, if the multiplier effect of government investment is greater than one, then there can be an increase in economic growth.

For example, if the government increased spending on roads and railways, there would be a direct increase in demand from the government spending, but there could also be knock on effects to the rest of the economy. Construction firms would take on unemployed workers; these former unemployed workers would now spend more – causing a further round of increased spending in the economy.

Furthermore, they may also be a supply side impact from the investment. Business say the lack of another airport in London is holding back investment in the South East. If capital spending increases transport links, it can benefit the supply side of the economy in the long term, which is an additional benefit to long term economic growth.

Also high profile capital expenditure projects may help to boost consumer and business confidence. Therefore, this could increase spending and Aggregate Demand even more.

Read more

Is the UK Economy Healing?

The Chancellor recently spoke on the Andrew Marr show. G.Osborne said of the UK economy: “We are getting on top of the deficit… They are difficult times for the British economy; it’s a difficult time for the world economy, but our economy is healing. We have to do more and we have to do it …

Read more

Theory of Consumer Behaviour

Readers Question: what axioms underlie the theory of consumer behaviour? How reasonable are they? I have the axioms: completeness, transitivity, continuity, non-satiation and convexity. but we have never been taught about how reasonable they are and I can’t find any info anywhere! please  help

It is an interesting question. I am not really qualified to give a good answer as I am not familiar with some of the terms you mention. However, I will look at the issue from a more general perspective.

Rational preference

If a consumer prefers A to B and also prefers B to C. Then, it follows a rational consumer should prefer A to C.

E.g. you prefer Starbucks to Costa Coffee and you prefer Costa Coffee to McDonald’s then you should prefer Starbucks to going to McDonald’s.

Are there consumers who might, given the above, still prefer McDonald’s to Starbucks? It is pretty unlikely, but, consumers can always behave on a whim. It is not impossible.

Read more

UK Borrowing Figures 2012 Disappoint

UK borrowing was higher in July than expected. Overall public sector net borrowing came in at £600 million in July, compared with a surplus of £2.8 billion in the same month last year. City’s expectations had been for a surplus of £2.5 billion. Overall borrowing for 2012/13 is likely to overshoot the OBR’s forecast of …

Read more

Osborne Austerity Measures are not Working

The Chancellor George Osborne is coming under pressure to alter government policy and promote economic growth through higher public spending financed by government borrowing. After two years of focusing on deficit reduction, critics argue the government should change approach and concentrate on getting the economy out of the persistent recession. The IMF recently stated: “The …

Read more

Item added to cart.
0 items - £0.00