Trickle down economics

Trickle down economics is a term used to describe the belief that if high income earners gain an increase in salary, then everyone in the economy will benefit as their increased income and wealth filter through to all sections in society.

However others criticise this belief that if the top earners in society gain an increase in income, everyone benefits as a result. Some studies suggest that increased income inequality can lead to this inequality being solidified through educational opportunities, wealth accumulation and the growth of monopoly / monopsony power. Furthermore, increased inequality may lead to lower rates of economic growth.

A recent report by the OECD found that since the start of the credit crisis in 2008, inequality has widened in many countries; however this inequality has led to lower rates of economic growth not higher.

This graph from an OECD report suggests that inequality is responsible for lower GDP. The OECD estimates that the UK economy would have been more than 20% bigger had the gap between rich and poor not widened since the 1980s.

oecd-inequality

Source: OECD Focus – Inequality and Growth 2014

Trickle down effect and tax cuts

An important element of the trickle down effect is with regard to income tax cuts for the rich. It is argued that cutting income tax for the rich will not just benefit high-earners, but also everyone. The argument is as follows:

  1. If high income earners see an increase in disposable income, they will increase their spending and this creates additional demand in the economy. This higher level of aggregate demand creates jobs and higher wages for all workers.
  2. Alternatively, increased profits for firms may be reinvested into expanding output. This again leads to higher growth, wages and incomes for all.
  3. Lower income taxes increase the incentive to for people to work leading to higher productivity and economic growth. Continue Reading →

Does the UK have a housing bubble?

Readers Question: Do you think the help to buy scheme is fuelling a housing bubble? Only about 3% of houses are bought through this method but do you think that it is likely that a bubble will develop?

In a way, I think you answer the question yourself in stating that only 3% of houses are bought through this method

With such a small percentage of homes bought through this scheme, it is not going to be a major cause of a housing bubble; however, in a relatively significant way, it will add to housing demand. Given the inelastic nature of housing supply, it will make a contribution to pushing up house prices.

Without the help to buy scheme would people have bought houses anyway? I’m not sure. I think the scheme will definitely help some to get a mortgage, and therefore buy rather than renting. In that regard it is adding to housing demand, and therefore pushing up prices, but only a small amount.

Will a housing bubble develop?

This is a more difficult question. There are different types of housing bubbles.

One is the housing bubble experienced by US, Ireland and Spain – where property prices rose substantially above average earnings, and then fell by up to 50%. This is because house prices in these countries became divorced from the fundamentals of housing supply and demand. When the mortgage market experienced difficulties, demand fell and prices fell significantly. The crucial thing about US, Ireland and Spain was that after the housing bubble and bust, there was a large excess supply of housing. Therefore, when demand fell, prices fell considerably.

uk-irish-house-prices

See: Ireland Housing bubble and bust

The UK housing market behaved differently. When demand fell in 2007/08 because of the credit crunch, prices did drop by 20%. But, house prices stabilised much quicker, and then – defying many predictions – began to rise quite rapidly. Meaning that in the UK, house prices in many areas are higher than before the crash.

The main difference is that in the UK, there was no excess supply of housing; there was no boom in home building. Therefore, when the crash came, there was still this fundamental shortage of housing, which keeps prices ‘artificially’ high.

Why UK property prices may be overpriced

uk-house-prices-2001-2013q2

  • Interest rates set to rise. UK interest rates have stayed at zero since early 2009; this period of ultra low interest rates has benefited the property market and kept mortgages affordable. If interest rates rise back to ‘normal’ rates (e.g. around 5% – many homeowners will see a sharp rise in the cost of mortgages, causing demand to fall. The Bank of England recently did a survey and found a two-percentage-point rise in mortgage interest rates would likely raise the proportion of mortgagors with a debt service ratio (DSR) of at least 40% from its current level of 4% to about 6% (360,000 to 480,000 households)

    nw-affordability-index

    UK housing – prices kept affordable by low interest rates.

  • House price to income ratios. House prices have risen much faster than incomes, meaning the younger generation are not able to get a mortgage. The average age of mortgage holders has increased, and the deposit required has also gone up. Because house prices are so expensive, there are many who cannot consider buying.
    ftb-house-price-earnings

    House price to earning ratios for first time buyers. The ratio is 5.0 significantly higher than previous decades.

  • Buy to let market. With home ownership rates falling, the growth in demand for housing is coming from investors.

    housing

    These investors are more likely to be sensitive to changing house prices. If there is a sustained drop in prices, this may be magnified by investors leaving the UK housing market.

  • Economic growth is still fragile. Although the UK recovery is reasonably strong, the Eurozone looks weak with anaemic growth and the threat of deflation; there is a strong possibility that a weak EU economy could act as a drag on UK growth.

Continue Reading →

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UK Housing Market Stats and Graphs

A look at the main UK housing market data.

  1. House prices
  2. Affordability of housing
  3. Interest rates
  4. Supply of housing

House price inflation

house-price-inflation-90-2013

Nationwide data

  • Annual house price inflation running at 8.3% in Nov 2014
  • London showed strongest housing market with prices rising 21%
  • Price of a typical home is £188,810 (Dec 2014)

UK House prices in past few decade

uk-house-prices-2001-2013q2

  • In 1975, average house prices were: £10,388.
  • In 2014, average house prices are: £188,810.

Continue Reading →

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Diminishing marginal utility of income and wealth

Diminishing marginal utility of income and wealth suggests that as income increases, individuals gain a correspondingly smaller increase in satisfaction and happiness.

rad-cam

Radcliffe Camera – built with donations by wealthy benefactors, but is there a diminishing utility of wealth?

Utility means satisfaction, usefulness, happiness gained. Utility could be measured by the amount you are willing to spend on a good.

Marginal utility of first £100

If you have zero income, and gain £100 a week. This £100 will improve your living standards significantly. With this £100 you will be able to pay for basic necessity of life – food, drink, shelter and heating. Without this basic £100 a week, life would be tough.

Marginal utility of income increasing from £500 to £600 (6th £100)

However, if you already gain £500 a week, an extra £100 has a proportionately smaller increase in utility. You  may be able to eat out at restaurants more often, but it doesn’t significantly affect your standard of living and happiness. At £500 a week, you can afford most things you need. But, still most people would be happy to gain an extra £100 to spend on luxuries like going out.

Marginal utility of income increasing from £10,000 to £10,100

If you are earning £10,000 a week – you would hardly notice an extra £100 a week. You may not even have time or ability to spend it; this extra income is liable to be just saved. Therefore, we say the marginal utility of an extra £100 at this income level is very limited.

Therefore as income increases, the extra marginal benefit to individuals declines.

Diminishing marginal utility of wealth

Income is the amount of money received per time period. Wealth is a stock concept (the amount of savings, property owned)

It is a very similar effect with wealth. If you have savings of £10,000 – this can be useful for giving you insurance in periods of unemployment or the need to buy large items, like a new cooker. If you own one car, it can be useful for getting to work. Also, owning a house is a form of wealth and it is important for giving you a place to live.

However, suppose your wealth increases. If you now own two cars, the extra benefit is much diminished compared to the first car. It might be useful to have two cars in case one breaks down, but you can only drive one at a time. If you have 7 or 8 cars like a collector, you may get some joy from having a collection, but the extra utility of that 8th car is significantly lower than the working person who has just one car to get to work.

Continue Reading →

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Paradoxes of Coalition Government

How has the coalition government fared on its economic policies?

Firstly, there are quite a few paradoxes.

Ignore own promises. The first paradox of the coalition government is the best thing they did was to ignore their own advice. When they came to power, they promised spending cuts, austerity and a balanced budget within a few years. Fortunately, when they realised the damage they inflicted 2010-12, they quietly gave up on this serious austerity plan and delayed any major spending cuts until sometime tomorrow (or if you prefer, until someone else is chancellor)

UK-government-spending

It is a great relief they failed to meet their budget deficit targets. Many admonish the government for failing to meet their budget deficit targets. Borrowing is currently £91.3 bn – much higher than the initial long-term target of £40bn. But, my only real emotion is relief. If we had insisted on cutting an extra £50bn of public sector spending, the economy would resemble Italy, Portugal or maybe even Greece. We would certainly not be seeing economic growth of 3% and falling unemployment.

uk-net-borrowing-percent-gpd
In the land of ‘tomorrow, always tomorrow’ – this time the government has promised to balance the budget by 2019/20 –  there cannot be anyone who takes the government seriously on this- not least the bond market. But, as usual it doesn’t really matter.

Borrowing wasn’t so bad after all. In 2010, many very serious people were warning over the dangers of high government borrowing. There were no shortages of apocalyptic warnings that unless we immediately get borrowing under control, inflation and bond yields would immediately rise and we would soon resemble a quasi Zimbabwe economy. Of course, neither has happened. Bond yields are at record lows and and inflation is below the Government’s target. It’s never been so cheap and easy for the government to borrow.

10-year-bond-yields

Bear in mind, bond yields are expected to rise with economic recovery.

Conclusion

Everyone seems to agree the chancellor is the most political of chancellors – to the cynically minded, every economic decision seems to be calculated to improve the Conservative chances in the marginal constituencies. This is not all bad, the democratic mandate does at least curb some of the elitist instincts of the party. Perhaps the desire to please the electorate was a significant decision in delaying austerity. Without a looming general election, perhaps we would be moving towards a US style private health care.

Overall, there is a sense it could have been worse – especially compared to Europe. But, ‘it could have been worse’ is not the highest praise.

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Falling UK tax revenue

A few years ago, I wrote several posts about the need for a government to borrow in a recession. One thing I would have said is that when the economy recovers, tax receipts will automatically rise and the deficit will fall. You could almost say ‘solve unemployment and the deficit will take care of itself.’

The logic is that even if you keep tax rates the same, economic recovery will lead to higher tax revenues, for example,

  • With greater consumer spending – VAT and Excise duty revenues will rise
  • Rising incomes will lead to higher income tax and NICs.
  • Greater profitability will lead to higher corporation tax.
  • Recovery will help housing market and stockmarket lead to more stamp duty and capital gains.

However, one feature of this recovery is that tax revenues have proved disappointing. Tax revenues have increased by a small amount, but as a % of GDP, tax receipts are struggling to keep up. In particular, corporation tax and income tax have fallen behind schedule.

hm-revenue-tax

This shows overall nominal HM Revenue and Custom revenues. Not adjusted for inflation.  (Note. This also excludes other sources of Government revenue) See Tax revenue sources for more detail.

  • In 2007/08, tax receipts were £451 bn
  • In 2013/14 tax receipts were £489 bn

This is very weak growth, when you remember these are nominal figures.

Continue Reading →

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Government spending cuts to 35% of GDP

Firstly, I thought it might be helpful to talk about the different types of spending cuts that people refer to.

  • An actual cut in government spending. e.g. one year we spend £39bn on defence, the next year that is cut to £38 bn. This is a nominal cut of £1bn. The real cut will be even bigger.
  • A cut in real government spending. If inflation is 3% and government spending on education rises by 1%, that is a real cut of 2%. Departments will still have to cut back on wages and spending because with inflation higher than spending rises, they can afford less spending. It is fair to call this a spending cut
  • A cut in % of real GDPgovernment-spending-percent-gdp-obr-14Note figures for 2018-19 are a forecast. The big issues is that the Chancellor has proposed reducing the size of government spending as a % of GDP to lowest since 1948. Real government spending will rise, but as a % of national income it will be lower.

    Suppose, real GDP rises by 3%, but one department sees a rise in real spending of 1%. In this case, the department has a smaller share of national income, but at the same time has a real increase in the amount of money. This isn’t a cut in government spending, but it is cutting the share of GDP spent on that department.

  • A cut in quality of services. This is even more subjective. Suppose economic growth is 3% a year, but we increase the NHS budget by 4%. This is a real increase, and we are spending a higher % of national income on health. However, some may argue the demand for health care is rising by 8% a year due to rise in number of old people, rise in obesity e.t.c. Therefore, unless we match the demand for rising health care, it will lead to a cut in the quality of service and a rise in waiting lists. It is disingenuous to call a 4% real rise in spending a cut, but people’s experience of the NHS may feel like they are experiencing a cut.

Government spending as a pie chart

UK-government-spending

Which piece of pie should be cut?

Continue Reading →

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Cut in UK stamp duty

The government have announced a change in stamp duty. The chancellor George Osborne claims the change to stamp duty will cut the rate of tax for 98% of house purchases.

New marginal tax rates are:

  • 0% tax on house purchases up to the value of £125,000
  • 2% tax on purchases between £125,000 and £250,000
  • 5% tax on purchases from £250,000 up to £925,000
  • 10% tax on purchases from £925,000 to £1.5m
  • 12% tax on purchases over £1.5m

The tax change will cost the public purse £800m and represent a £4,500 cut in tax on average home of £275,000.

UK stamp dutySource: Guardian

For an average priced home of £275,000, there will be £4,500 cut in stamp duty.

Commentary

Firstly, it makes sense to get rid of the old system, where a £1 increase in house price could cause £3,000 extra tax. Marginal tax rates avoid this tax-cliff, which distorted house sales around the stamp duty rates.

It is also very progressive, with a steep increase in tax rates for more expensive houses. In some ways the new stamp duty is a weak substitute for the proposed mansion tax.

However, there are two main problems.

1. This is not a good time for tax cuts. Given the need to improve public finances, it seems strange to offer a big tax cut on stamp duty. Revenues from stamp duty have already fallen significantly since 2008 because of lower house sale volumes. This tax cut will worsen public finances. It would be better to avoid a tax cut for stamp duty and have an extra £800m to spend on infrastructure (like for example, building affordable social housing).

Some might say, ‘But, you often argue for expansionary fiscal policy, so why not support a tax cut to boost spending and support economic growth?” – Well firstly, the aim of this tax cut is not to boost economic growth. If you did want to pursue expansionary fiscal policy, you would cut VAT or income tax. Increasing income tax threshold would increase consumer spending, but I’m not convinced a cut in stamp duty would have much impact. A cut in stamp duty is not really going to encourage people to go out and spend supporting a sustained economic recovery.

With stamp duty cut we get the worst of both worlds – we get a deterioration in public finances, but it doesn’t even offer much help to the economic recovery. Continue Reading →

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The great housing boom

Readers Question: In 2008, did banks lend money to people who wanted to buy a house because they believed that the value of the housing market would keep rising? So even if people defaulted on their loan repayments then the banks could reposes the house as it was used as collateral. As the value of the house would be of greater worth than the loan so that the banks could make a profit. Is this correct? Thanks!

This is partially correct. The great housing boom lasted from 1994 to 2006/07. But, in particular the period 2000 to 2007.

Mortgage lenders in both the US, UK and Europe became very keen to lend more mortgages because of rising prices, but also other factors, such as over-confidence, ability to borrow short term money / resell mortgage bundles. There were also significant differences between US lending and lending in Europe. In the US, mortgage lending was the most aggressive. UK and Europe retained some controls, but even so, mortgage lending rose sharply.

US Housing boom in historical context

us-housing-prices-Shiller_IE2_Fig_2-1

US house prices historical context – Shiller at wikipedia

The US Housing boom

The US housing boom was caused by a number of factors, but extravagant mortgage lending was a key factor.

  • Rising property prices created a positive wealth effect. This encouraged people to try and get on the property land (people who previously rented).
  • Rising house prices also encouraged banks to lend mortgages because – as you say – even if people defaulted, the bank could make a profit on its mortgage lending by selling the house at a higher price. Usually lending a mortgage is quite a good investment for a bank, especially if house prices rise.
  • The rising demand and rising supply of mortgages created a strong effect for pushing up house prices. It became a mutually reinforcing circle. Rising house prices encouraged banks to lend. More bank lending encouraged people to buy, pushing up prices.
  • Over-confidence. This climate of rising house prices definitely encouraged over-confidence in the banking sector and amongst householders. There was a feeling that housing was one of the best forms of investment – you couldn’t go wrong with a house.
  • Short-term bonuses. In the US, a feature of mortgage lending was that people were employed to sell mortgages who had no interest in checking whether it was suitable in the long term. There were very lax mortgage controls. Mortgages were sold with ‘teaser’ deals to make the first two years cheap and the later higher rates hidden from view. These mortgage sellers were not considering whether it made sense, they were just trying to sell the mortgages to get their commission. Financial bodies were happy to have these rogue salesmen because they thought house prices would keep rising. Also, bankers often got substantial bonuses from the mortgage boom; risky lending often paid high bonuses – encouraging a climate of risk taking.

Continue Reading →

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UK Government spending – real and as % of GDP

In 2013/14 the UK government is forecast to spend a total of £ 722.9 billion – nearly double 2000/01 spending of £359.6 billion

UK-government-spending

Source: ONS Public Sector Finances MF6U – October 2014

Government spending as % of GDP

g-spending-percent-gpd-96-14

Updated Forecasts of Government spending from Autumn Statement of Dec. 2014

government-spending-percent-gdp-obr-14

Source: OBR, Dec 2014

Note 2013/14, government spending as a % of GDP is approx 41.2% of GDP. This is forecast to fall to 25% of GDP by 2018-19. This will require several years of great government spending restraint and high economic growth.

Government Spending and borrowing

Of this government spending:

  • Current spending = £671.5 bn
  • Capital spending = £51.3 bn

Background to government spending

In 2000-01, several years of government spending restraint combined with rising economic growth, saw government spending shrink to under 35% of GDP. Between 2001 and 2007-08, spending rose to over 40% of GDP due to sustained increases in spending on health, education and welfare spending.

  • Between 2008-09 and 2009-10, the UK saw a large drop in real GDP of 6%, but due to automatic stabilisers government spending increased (e.g. higher unemployment benefits). This caused government spending as % of GDP to rise to 47%.
  • Government spending as % of GDP is forecast to fall closer to 40% of GDP by 2016-17 (if growth targets are met)

Continue Reading →