Prospects for Recovery in the UK economy 2012?

Given very low expectations, there are some encouraging signs for a weak economic recovery in the UK. The OBR increased growth forecasts to 0.8% in the UK for 2012. Helped by the recovery in the service sector, it looks like the UK will avoid a double dip recession. This still leaves GDP below the 2008 …

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Explaining Paradoxes of UK Economy

Readers Question: There just seems to be many paradoxical actions taking place in markets and economies at the moment. How do we explain?

Paradoxes of UK economy

  1. Low interest rates have not increased spending / economic growth
  2. Despite recession, inflation has been above target.
  3. Despite recession and depreciation of Pound, current account deficit increased in size in 2012
  4. Spending cuts failed to reduce the budget deficit as the government hoped.
  5. Despite a longer recession than great depression of 1930s, unemployment is lower than in other more moderate recessions.
  6. Record levels of government borrowing have led to a record fall in government bond yields (the opposite of what  some people predicted)
  7. Quantitative easing (increasing money supply) has not actually increased the money supply !

How to explain these paradoxes

1. Zero interest rates have not increased spending

real gdp and trend

For the past few years, we have been experiencing an unusual combination of circumstances where many ‘ordinary’ rules of economics are not occurring. The economy is currently experiencing a liquidity trap. A liquidity trap involves:

Low-interest rates failing to increase demand. Usually, lower interest rates boost spending because it is cheaper to borrow; but in this current economic situation, even interest rates of 0.5% have failed to see a rapid increase in aggregate demand. Low-interest rates have failed to increase spending and investment because

  • Confidence is very low. People don’t want to invest when a double-dip recession is forecast. People are reluctant to spend when they fear unemployment
  • House prices and other assets have fallen. Therefore, this creates a negative wealth effect and discourages spending.
  • Banks are reluctant to lend because of their liquidity shortages. Therefore, although it is in theory cheap to borrow, it is difficult to get a loan in the first place (e.g. mortgage criteria have become much stricter)
  • Banks have a funding gap. This funding gap explains why extra money supply from Quantitative easing hasn’t led to higher bank lending – they have been trying to improve their balance sheet.
  • Although Central Bank base rates have fallen to 0.5%, many commercial banks haven’t passed these interest rate cuts onto consumers
  • See also: expansionary monetary policy
  • UK recession of 2008-13 is longest on record

2. Despite recession – inflation above target

Despite a prolonged recession, inflation in the UK has been above target. Firstly, inflation has only been moderately above target. But, with falling wages, many households have seen a fall in their real wages – inflation has been higher than income growth. Therefore, this moderate inflation has been much more noticeable than usual. If your incomes are rising, you don’t mind price increases. But, this recession has seen an unwelcome combination of rising prices and falling wages – reducing living standards.

But, usually in a recession, you would expect a lower inflation rate (lower demand leads to lower prices, higher unemployment leads to falling wages e.t.c). Why has this not occurred?

The inflation is not due to the usual causes of inflation (excess demand in the economy).

cpi-inflation

Inflation in the UK was high between 2008 and 2012 because

  1. Rising price of oil – causing cost push inflation
  2. Higher tax rates – causing one-off increases in tax
  3. Impact of depreciation – causing a rise in import prices
  4. Rising energy prices, such as gas and electricity.

When these temporary factors are stripped away, the underlying core inflation is actually quite low. See also: inflation stats

3. Despite recession and depreciation of Pound, current account deficit increased in size in 2012

 current-account-quarterly-2007-2012

In the latter part of 2012, the UK pound fell in value. Also, the double-dip recession led to lower consumer spending. Usually, this leads to an improvement in the current account. A depreciation makes exports cheaper and imports more expensive. A recession reduces spending on imports. Both should improve the current account.

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Global Imbalances

What are the Global Imbalances? US ran a large and persistent current account deficit (imports higher than exports) of up to 6.5% of GDP in 2006 Diagram of Current Account Surplus / Deficit in US and rest of world source: (1) 2. China ran a large current account surplus, accumulated foreign reserves, kept Yuan undervalued …

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Do stock markets reflect the model of perfect competition?

Perfect competition is a market structure with the following features Many buyers and sellers – 1000s of firms. Freedom of entry and exit into the market Homogenous good Perfect information In a way, stock markets are an example of perfect competition. There are hundreds of buyers and sellers. When buying shares you can choose from …

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Question: Why does economics create so many opinions?

Readers Question: Economics is a social science, it contains graphs, diagrams and statistics to make strong evaluations and at university level it also often seems to have a strong Maths content which allows for even stronger analysis, calculation of events and evidence of theories. So how is it possible that often economic events such as inflation or recession can be unexpected and that economists have different opinions on why, when such events may occur?

One part of economics is to look at data and try and create models out of this data. The aim is to try and understand why economic events occur and from these models predict the likely outcome of changes in policy. All models will be dealing with what has happened previously, for example, you might look at various indices related to inflation, and come to the conclusion that recent UK inflation was due to a combination of higher taxes, higher petrol prices and the effects of devaluation.

Therefore, all models risk being inadequate because they cannot guarantee to take all events into consideration. For example, in the mid-2000s, it appeared we had a great moderation – low inflation and low growth. But, from 2006, the credit crunch had a much bigger impact on the economy, than any previous situation. Models had failed to take into account the potential adverse consequereal-gdp-uk-2000-2019-actual-realnces arising from a sudden drop in bank lending.

Difficult of Forecasting

When it comes to forecasting inflation, you can make the best estimates, but there is always an element of unpredictability. For example, in 2012, the Bank of England forecast the inflation rate would fall. This seems a reasonable forecast on the basis that

  • wage inflation is low
  • economic growth is low.
  • Temporary cost-push factors should expire.

However, you can never predict the future with certainty. There could be another oil price shock (e.g. war in Iran). If the economy recovered quicker than expected, we may also see a return of demand-pull inflation.

Another issue could be the inflationary impact of quantitative easing. Usually, economic theory would suggest that increasing the money supply would cause inflation (link between money supply and inflation). However, there are always many variables to take into account.

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Quantitative easing and impact on savers

Quantitative easing aims to stimulate the economy and reduce gilt yields. A consequence of this is that lower bond yields lead to lower income for savers. This particularly affects pensioners who rely on income from savings to provide for their retirement.

Since QE was implemented in March 2009, the income paid by pension annuities has fallen by a quarter (FT).  The decision to pursue quantitative easing has also been criticised for effectively redistributing income from savers to borrowers.

However, though quantitative easing may have impact of reducing bond yields it is worth bearing in mind, the following.

  • Falling bond yields are not just due to quantitative easing. They reflect investors desire for security and reflect their concerns over future economic growth. Even without quantitative easing, you would expect falling bond yields from the state of the economy. (see: why are bond yields falling)
  • Falling bond yields have helped to boost prospects of economic growth, which ultimately is essential for the the long term performance of pension funds. If the economy gets stuck in a deflationary trap and persistently low growth, then there will be a sustained fall in the value of pension funds – more serious than the temporary drop in bond yields. The effects of Quantitative easing are probably fairly limited, but it is still one of the few ways to boost economic activity.
  • Falling bond yields have helped to make shares more attractive. Given falling bond yields, there has been some shift into shares. Also, share prices have been helped by the  prospect of stronger economic growth. The All Share index is 50% higher than in March 2009. Quantitative easing has played a role in boosting the prospects of shares. Therefore, although pension funds have seen a fall in income, the rise in share prices has helped to offset this decline in income.

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Question: Are people hungry because the world does not produce enough food?

Readers Question: Are People hungry because the world does not produce enough food? No. Essentially it is a problem of distribution. In particular, in developing countries, many people lack sufficient income to buy enough food The United Nations, World Food Programme WFP, states 925 million people do not have enough to eat and 98 percent …

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Questions on Money Supply and Inflation

Readers Question: Does money printing/QE always lead to inflation and price increases? No. Increasing the money supply does not necessarily cause inflation. In particular, we have seen a large increase in the monetary base (narrow money) that hasn’t led to an increase in the general price level. If you look at link between money supply …

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