Definition of Debt Hangover - A situation where agents (firms, governments, individuals) hold too much debt holding back normal economic activity.

Definition of Debt Overhang - a similar situation. Debt overhang occurs when the interest burden of existing debt is greater than the profit the firm can generate from its core business. Debt overhang was a situation faced by many banks during credit crisis.

Debt imposes the cost of debt interest repayments. A high level of debt increases the cost of servicing debt. If this cost of paying debt interest payments is too high then firms may be reluctant to invest and individuals reluctant to spend - governments may have to increase tax. Thus debt can be a constraint to economic recovery.

A further problem is when debt interest payments are so high, firms or individuals lose hope of ever getting on top of their debts so are encouraged to default on debt.

At the moment the cost of our debt hangover has been diminished by the record low interest rates. However, as interest rates rise back to normal levels the cost of servicing debt will come as an unwelcome shock.

The Culture of Debt in UK

Among households, debt-to-income ratios have risen significantly over the past twenty
years. In the UK, household debt-to-income ratios rose from around 100% in 1988 to
a peak of around 170% in 2008. (1) see also: Personal debt in UK

The Great recession has also led to a significant rise in public sector (government debt). The UK's rise in public sector debt is well documented. The IMF forecast that the public sector debt ratios of the G7 will rise from 80% (2007) to 125% in 2014 (1)

Gross Debt.

Gross Debt it the total debt of the economy - combining government, private and corporation debt. Th is is important because it shows the combined debt of an economy. For example, one justification for deficit spending in Keynesian economics is that the government needs to borrow to offset a rise in private sector saving during a recession. However, if the government is borrowing more - but also, the private sector still have high debts, this is more of a problem.

According to the McKinsey Global Institute gross debt has risen 60% by $40 trillion in ten leading developed economies. This is roughly split between the three main sectors.

References
(1) The Debt Hangover at B of E Andrew Haldane

(2) McKinsey’s Global Institute (2010), “Debt and Deleveraging: the Global Credit Bubble and its
Economic Consequences”. http://www.mckinsey.com/mgi/publications/debt_and_deleveraging/index.asp

As I mentioned last week, the Eurozone is far from being an optimal currency area. The current recession has made the difficulties of the Euro become more prominent - especially for the peripheral areas of the Eurozone - Portugal Ireland, Italy Greece and Spain.

The Problems Facing Greece are:

Rising Government Debt to over 100% of GDP. A budget deficit of 12% for this year. This level of debt has started to make markets wonder whether the government might default. This fear has led to people selling Greek bonds and pushing up the interest rate. Greek debt is now much more expensive than German Debt.

Uncompetitive Economy. The Greek economy is uncompetitive. Rising wages have not been matched by rising productivity. THe lack of competitiveness has led to a fall in demand for Greek goods and a very large current account deficit (imports greater than exports)

No Ability to Devalue. If Greece had their own currency, the currency would devalue to help restore competitiveness. But, being in the Euro, they are not able to devalue and regain competitiveness.

Recession. Greece GDP fell last year by 1.2%. This increases the budget deficit and leads to higher unemployment.

So Called Solutions will Only Make Things Worse. Greece is being told it needs to tackle its fiscal deficit with immediate effect. This involves - higher taxes, cuts in public sector wages and lower government spending. But, when the economy is facing - a fall in output, rising unemployment and the very real threat of deflation a deflationary fiscal policy without a corresponding loosening of monetary policy could make things worse. - The budget deficit does need to be tackled, but, the economy needs some monetary stimulus (Quantitative easing and to prevent a collapse in demand

Needless to say, the triple whammy of higher taxes, lower wages and cuts in government spending are about as politically popular as suggesting Greece bailout the Turkish economy. - Greek farmers are already protesting

Some think the main EURO members (i.e. Germany ) will bailout profligate Greek taxpayers and inefficient governments. It's the same kind of mindless optimism that certain British politicians had in 1992, when they fully expected Germany to bailout the Pound and keep it in the ERM. (Britain soon was forced out and devalued 20% - much to the relief of the economy it has to be said.) But, I really can't see the German taxpayer bailing out not just Greece, but, Italy and other members.

The Greek economy is in a real mess - and it's not just the high government debt that is the issue. In fact solutions, to reducing debt could cause a deep recession (which will reduce tax revenues even further.) They need to tackle the deficit, whilst boosting the economy in other ways. At the moment, they are being asked to do all the painful things without any anaesthetic.

Related

• Arguments against joining the Euro
• Greece Economy

Graph showing comparisons of Recessions.


Note in the Great Depression output in UK fell 10% (In US GDP fell by 30% - but UK did not have boom in 20s or 30s - UK unemployment was already high by 1929.)

In terms of GDP fall, the UK recession is the worst since the Great Depression. It is also the longest (6 consecutive quarters). Last quarters growth of 0.1% is so feeble it means it could have easily have been 7 quarters.

Another feature of this great recession was the rapid fall in asset prices in 2008. A fall in asset prices is often an indication of a depression - rather than just recession. This is one reason why so many economists were worried in 2008

Yet, other factors suggest it could have been worse.
Comparing Unemployment, the rise has been relatively modest given output decline.

source: B of E (pdf)
See also: Why is UK unemployment not higher

Also, a positive sign for this recession, is the relative recovery in business and consumer confidence.


source: B of E (pdf)

This upturn in confidence may explain why firms have been keen to retain workers - rather than make redundancies - it may suggest a positive expectation about the medium term.

Housing Recovery

In the 1990s, house prices fell for four years, real house prices (adjusted for inflation) remain below the boom peak for several years until after 1997. So far the housing market has recovered far quicker. Whilst some may state that this is only a temporary recovery, one difference in this recession is that there wasn't the same increase in housing supply. Thus, we do not have to deal with excess housing supply depressing prices (this excess housing supply is a big problem for US, Spain and Ireland)


source: B of E (pdf)
see also: Impact of house prices on consumer spending

Other factors in this recovery is the sharp devaluation of sterling in past two years. As the global economy recovers, the UK should be in a good position to benefit from growth in trade.

This paints a rather rosy picture. But, there is unfortunately more. In particular the hangover of debt - both government, corporate and household. Currently cushioned by low interest rates, as the economy and interest rates recover to normal rates, the record levels of debt will be a factor holding back growth - banks will be reluctant to lend, households will be looking to pay back debt and governments will have to improve fiscal position.

Related

• essays on recessions
  
• Recession Tracker at BBC

We have been in the longest recession since the great depression, so it is somewhat suprising to see a rise in inflation. This includes both the RPI and CPI measures. CPI is 2.9%, RPI is 2.4%. When the inflation rate rises above 3%, the governor of the Bank of England has to write a letter of explanation to the Chancellor. He is already drafting a response as the Bank of England expect inflation to peak at over 3%, when the rise in VAT from 15 to 17.5% is included.

Why Inflation?

• Depreciation in Sterling makes imports more expensive. About 40% of goods are imported, when the pound devalues as it did in 2008/09, it makes imports more expensive.
• It is a reflection that prices fell in December 2008 by 0.4%. By contrast last month they rose by 0.3%.
• Oil prices rising relative to 2008

Factors which aren't causing Inflation?

• Quantitative Easing. You might expect that if you create £200bn of electronic money this increase in money supply should cause inflation. However, money supply growth is still 'undesirably low
• Wage growth is very restrained due to the unemployment and impact of recession. Wage growth was just 0.7% in 2009.

The spike in inflation will most likely prove temporary, but, the bad news in the short term is declining real incomes - Many people will be seeing prices rise faster than wages - hardly something to boost the economic recovery to say nothing of the political cost to Labour.

It is important to remember that inflationary spikes can be misleading to underlying state of economy. For example, the inflation spike in early 2008, just before the economy plunged into deep recession.

Related

• Fear of Inflation
• Definition of inflation
  

Since the 1970s, the UK government has been generally unwilling to subsides firms. The free market logic is that

• Government subsidies encourage inefficient firms to remain inefficient.
• Subsidies encourage firms to expand beyond the economically efficient output. (remember the CAP was a government subsidy to farmers which led to all those wine lakes and butter mountains e.t.c)

This logic explains why many UK industries had subsidies removed and were allowed to go under if necessary (e.g. British coal).

There is a certain economic logic to this. As an economist, I would only justify subsidies if the industry had positive externalities to society. E.g. Trains help to reduce congestion on roads and pollution. Therefore a larger subsidy to train travel would be justified on this grounds. But, generally there is a real danger subsidies could lead to inefficiency and are wasted resources.

So what about the Bank bailout? Is that not a subsidy? The answer is Yes - a contingent subsidy, but still a subsidy of over £140bn nonetheless.

Governments have made it very clear that they will not allow banks to fail. If banks overreach themselves they can rely on government (taxpayer) subsidy to however much they need.

There may well be good reasons as to why we don't allow banks to go bankrupt (the number of US bankruptcies in Great Depression of 1930s is sufficient reason)

But, the problem is we have created a system of moral hazard. The government is effectively encouraging banks to expand beyond the sensible level. It encourages banks to take unnecessary risk. As I have said before, heads banks wins, tail taxpayer loses).

A bank tax can therefore not only be justified but seen as necessary to provide a necessary counterbalance to undesirable bank expansion and bank risk.

If designed properly a bank tax can be used to:

• Tax excessive risk taking
• Encourage banks to take more responsible lending practises.
  
• Build up a fund to provide for any future bank bailout.

Banks will say they are being unfairly discriminated against, they will complain it is populist politics. They will say they have definitely learnt the mistakes of the naughty naughties. But, does anyone believe the banks are not capable of making exactly the same mistakes they made in the last decade?

And the tax may just help to repay the national debt which has been made far worse by the scale of financial bailouts.

There are few economic factors as influential as consumer confidence. On the hand it is somewhat elusive based on the attitudes and perceptions of householders. But, consumer confidence has the power to make or break economic policy.

UK Consumer Confidence



Consumer confidence is based on a sample survey with a range of people asked questions about the state of the economy and their expectations for the future. These questions include:

• Appraisal of current economic conditions
• Expectations regarding economic conditions six months hence
• Appraisal of the current employment conditions
• Expectations regarding employment conditions six months hence
• Expectations regarding their total family income six months hence

Respondents can answer positive, negative or neutral. Consumer Confidence Index CCI is an aggregate of all 5 answers.

What Influences Consumer Confidence?

Expectations are largely based on the current economic situation and reported news. News of job losses and falling house prices are amongst the key factors which influence consumer confidence. The graphs certainly show a strong relationship between economic performance and consumer expectations.

Importance of Consumer Confidence

Consumer confidence can radically affect the effectiveness of economic policy. Suppose the Bank of England cut interest rates from 5% to 0.5% - in theory this gives consumers more disposable income to spend. However, if consumer confidence is falling, they are much more likely to save this extra income. Therefore, the interest rate cut may be ineffective in boosting spending. This is exactly what happened in 2009. Certainly other factors kept spending low (banks unwilling to lend, banks not passing the base rate onto consumer). But, low consumer confidence was one key factor.

If consumer confidence is very high, consumer spending is likely to rise despite higher rates.

Self-Fulfilling Expectations

In theory, it is possible for consumers to think themselves into a recession. If people expect a recession, confidence drops, spending drops, creating a negative multiplier effect of lower growth and higher unemployment. This in turn causes more falls in consumer spending.

In reality, consumers don't expect a recession without some good reason. Recessions have more causes than an unexplained fall in confidence.

Consumer Confidence and Saving Rates

There is an inverse relationship between saving rates and consumer confidence. When confidence falls the immediate reaction is for households to increase savings and reduce borrowing. This makes sense if you fear unemployment, it is not the time to engage on a borrowing spree. Since the summer of 2008, the UK savings rate has risen as confidence as fallen.

Outlook for Consumer Confidence in 2010

Predictions for economic growth is grim. But, news of the end of the recession and stabilisation in house prices has helped improve general expectations. This will certainly help the economy weather tax rises and the low wage growth.

Related

• Consumer Spending
• Definition Consumer Confidence

Recently, I talked about the problem of a common interest rate for the Eurozone area. See: problems of Euro and common monetary policy.

A common question is often - How come the United States of America doesn't need a separate interest rate for each individual state? For that matter why don't we have a separate interest rate and currency for London, Norfolk and Yorkshire. (Actually, being a supporter of Yorkshire Independence I think there's a good case of Geoffrey Boycott becoming President of a Yorkshire Central Bank, but, let's leave that for the moment...)

It is all to do with an optimal currency area.

An optimal currency area is a geographical zone where the benefits of a single currency outweigh the disadvantages.

Suppose, Wales experiences an asymmetric shock (coal mines close down). This would cause a recession in the Welsh economy, higher unemployment and lower inflation. Ideally, Wales would have a lower interest rate and a depreciation in a Welsh currency. But, in practise, it is possible for unemployed Welsh workers to move 100 miles east and get work in the Midlands or London. It is also relatively easy for London firms to invest in Wales to take advantage of lower labour costs and surplus labour. The point is there are not many geographical barriers to moving between areas within the UK. (There are, of course, significant geographical immobilities, but, they are not sufficient to justify a separate currency and monetary policy).

However, suppose there is an asymmetric shock in Italy and Greece, meaning their economies are in recession, whilst north Europe is growing strongly. It is much more difficult for Greek workers to move to Germany (language barriers, attachment to native country, poor information e.t.c). Similarly German firms would have much more reluctance to invest in Greece.

Political Problems

In theory, if there is higher unemployment in Wales, the UK parliament would be willing to give subsidies to Wales to help the area recover.

However, if the Basque region in Spain enters a deep recession, how committed would we be to sending more subsidies to Basques?

Even worse, suppose Greece has a serious debt problem (national debt of 123% of GDP would be a good supposition..) How willing would German tax payers be to buy Greek bonds and bailout Greece so that they can continue to spend over 5% of GDP on arming themselves against their Nato ally Turkey? (the point is there are many political problems)

If California went bankrupt, in theory, they would have more chance of getting US federal aid, than if Mexico went bankrupt. This is why the USA is an optimal currency area, But, Mexico, US, and Canada wouldn't.

What is the Eurozones optimal currency area?

There may well be an optimal currency area in Benelux countries and France and Germany. The difficulty comes when the Eurozone includes peripheral members such as the profligate Greeks, Italians and Irish.

The key issue is the degree of geographical mobility, government intervention and degree of economic convergence.

There are some who argue, the USA may not even be an optimal currency area, and would be better off having separate country for east and West.

I used to think if there was reincarnation, I wanted to come back as the President or the Pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everyone.

--James Carville, Clinton campaign strategist

In the 1990s, President Clinton tried to increase the US budget deficit, this led to a sell off of Government bonds, causing the Clinton administration to alter policy - instead of an increasing budget deficit, Clinton managed a rare budget surplus. This is an example of how bond markets can be very poweful.

The Bond market generally refers to the Government bond market, though there are also bond markets for corporate bonds and financial instruments like mortgage bonds. On the surface, bond markets look pretty uninteresting. Most people will have only a partial understanding of how they work and the impact they can have. Yet, below the surface of their respectability and anonymity, bond markets have the power to change government policy, and even change governments.

"I don't care a damn about stocks and bonds, but I don't want to see them go down the first day I am President."

- Theodore Roosevelt

Why The Bond Market is Important

Governments need to borrow money. They borrow money through selling bonds to the private sector. Usually, investors are quite happy to buy government bonds. They are seen as a safe investment (governments usually don't default) and the investor gets a guaranteed rate of interest in return.

Fear of Default

The problem with bond markets comes at the first sign of possible debt default.

If the bond market feels the government is borrowing beyond it's capacity. There is a chance that the government will not be able to repay its debt. The government may then create inflation to be able to pay back the debt. This reduces the value of bonds.

If there is a greater fear of debt default or default via inflation, then investors will require a higher interest payment to compensate for the risk.

Investors will send bonds, causing the price of bonds to fall and therefore the effective interest rate to rise.

The greater the chance of default, the higher the interest rate markets will require. This is why credit ratings can be very important. A downgrade in a countries credit rating from AAA to BBB means it is more difficult and more expensive to borrow.

This is very important for the government. Through the DMO, the government needs to sell something like £180bn of gilts and bonds this year. At the moment, the government can pay a relatively low interest rate on these gilts, because the bond market has the appetite to buy them.

However, if the markets lost confidence, in the governments fiscal position, bond prices would fall and the government would have to pay higher interest rates. When you have a national debt of £800bn, a 0.5% rise in interest rates is still a significant sum.

Often the fear of higher interest rates due to borrowing is exaggerated. So far, the government have been able to borrow as much as they need at relatively low interest rates. Japan is borrowing close to 200% of GDP and it hasn't spooked the bond market (yet).

But, the point is the bond market has the capacity to throw the governments best laid plans into confusion. There is no fixed level of debt when bond markets will turn. It doesn't just depend on levels of debt, but, issues such as political stability, expectations of future e.t.c

If the bond market froze up, it could force the government into painful choices. - Cut spending, increase taxes. It can be brutal.

Further Reading

• The Bond Market and the Financial Crisis
• Bond Market and the Relationship between bond prices and interest rates
• Impact of Rising Bond Yields
  

When I began economicshelp.org in early 2007, one of the first things I wrote about was the potential problems of joining the Euro. Recent developments suggest membership of the Euro could prove very costly for Greece, Portugal, Italy and Ireland.

Essentially membership of the Euro involves:

• Single Currency
• Single Monetary policy - interest rate set by the ECB.

What this means is that any member of the Euro cannot set interest rates and it cannot devalue (or appreciate) its currency.

This loss of monetary policy and exchange rate policy is not a problem if the Eurozone is an optimal currency area and the economies grow at the same rate. But, there is increasingly a divergence between different areas of the Eurozone - roughly a north - south split. The north (France and Germany) could recover strongly - this will cause ECB to put up interest rates and the Euro to appreciate.

But, in the south, deflationary pressures make recovery very difficult for the likes of Portugal, Greece and Italy. Also, the south have a much worse fiscal position.

This is the dilemma of the Eurozone - ideally, the south would have low interest rates, quantitative easing and a depreciation. But, the north doesn't. The ECB have great belief in their own powers and the necessity of the Euro project. But, this is not a dilemma which will easily go away.

Problem of Public Sector Debt.

One of the supposed Maastrict criteria of Euro membership was that countries should limit public sector debt to 60% of GDP. However, the recession and profligate fiscal policies have prevented this.

Greece has a public sector debt of 120pc of GDP this year. S&P says it will reach 138pc by 2012.

The solution is of course to implement deflationary fiscal policy - higher taxes and cuts in spending. But, when your economy is in recession this will lead to an even bigger fall in output.

Deflationary fiscal policy is OK, so long as you have something to offset it - a devaluation in exchange rate or looser monetary policy. But, Greece doesn't have this. Greece will be implementing the painful part but without the relief.

For example, in the coming years, the UK will need to tackle its fiscal deficit - this will be difficult given our anaemic growth prospects - but, at least we will be able to benefit from monetary policy as loose as we want and a weak currency. If we had to reduce our deficit with a very strong pound, higher interest rates and deflation - it would be a disaster.

The outlook for the Greek economy is very grim.

Already, they are facing deflationary pressure - making the effective real interest rates high and increasing the debt repayment burden.

They can't devalue and are suffering from a hefty loss of competitiveness.

The only policy tools available to increase competitiveness are the prospect of nominal wage cuts - not political popular - and of doubtful economic value. (cut wages and people spend less)

In fact, the most viable economic option Greece has at the moment, is to leave the Euro, devalue the currency, pursue looser monetary policy and reduce the structural deficit.

Of course, the other option is for the stronger Northern Euro members to have a massive bailout of the indebted south. But, the idea of German taxpayers bailing out profligate Greeks and Italians may test even the most ardent European idealist....

Further Reading

• Problem with the Euro
• Cost of Joining the Euro
• Benefits of joining the Euro
  

With unemployment continuing its remorseless rise in the US and the recession being the deepest since the Great Depression, it hardly seems credible to start fearing inflation. Yet, some commentators argue that the threat of inflation is just around the corner. In particular, they point to an explosion of the monetary base.

Monetary Base Growth in the US

via: G.Mankiw

The monetary base is a narrow definition of the money supply. It includes notes and coins in circulation and commercial bank reserves at the Central Bank.

The monetary base is sometimes called high-powered money because a change in the monetary base can cause a large change in the money supply due to the money multiplier effect.

In normal circumstances a rapid increase in the monetary base such as we see above would be inflationary. However, these are not normal circumstances.

• In US the Federal Reserve is paying interest on these reserves. This encourages commercial banks to hold onto these reserves and not lend them out.
• The economic climate is discouraging lending.
• Banks are trying to rebuild their damaged balance sheets. If anything, banks saying lending will struggle to be regained.
• The link between money supply and inflation is complex, depending on changes in velocity of circulation. As I mentioned a year ago - link between money supply and inflation
  

Another fear for inflation is the rise in government borrowing 'financed' by quantitative easing. But, I still don't think the deficit will have to be inflated away.

At the moment, there is alot of spare capacity in the economy. It would take a long time for the economy to reach bottle necks were firms can push up prices.

Expectations for inflation are low. Consumers fear unemployment and continued recession, not inflation at moment.

Inflation could be a problem in the future. If Central banks keep a loose monetary policy well into the recovery, inflationary pressures could re-emerge, but this is a future concern rather than an immediate pressing concern.

Related

• Why Printing Money Causes inflation

For homeowners, especially any lucky enough to be on a tracker mortgage, the current interest rate climate is an unspoken golden windfall.

Interest rates have never been this low in the UK, and the most likely prospect is for rates to remain close to zero for the considerable future.

There is no doubt that zero interest rates were the correct response to one of the most severe recessions and financial crisis of recent times. It is low interest rates that have helped avoid an even larger scale of home repossessions and have helped to prevent an even bigger fall in GDP.

Yet, whilst they are currently desirable, there is still a concern that the current interest rate climate could fuel another unsustainable boom in asset prices.

Interest rates are so low that investors are switching out of cash deposits and into assets such as shares and property.

It is this low interest rate climate that has helped witness a surge in share prices. The MSCI world index of global share prices is more than 70% higher than its low in March 2009. (source: Economist) It also helped to boost UK house prices, unexpectedly leading to a 9% rise in house prices in 2009.

Asset prices are still below historical highs. According to the Price / Earnings Ratio for the Dow Jones, US share prices are just above historical average of 17 (compared to a P/E ratio of over 40 at the start of 2000. (see: P/E at Greg Mankiw)

There may seem little sign of any boom in house prices at the moment. The recovery in UK high prices is hardly anything to get excited about, most commentators still expect them to fall this year. Yet, we shouldn't forget how easily we can forget...

Low Interest Rates and Deja Vu

One of the causes of the US mortgage fiasco was that exceptionally low interest rates were perceived to be normal and long lasting. To deal with the recession of 2001, the Fed aggressively cut interest rates to stave off recession. The low interest rates encouraged a raft of mortgage deals and rise in borrowing. It was ironic that efforts to deal with one financial crisis led to an even worse crisis a few years later.

We shouldn't forget such low interest rates are exceptional. When the economy returns to a normal path of economic growth, interest rates are likely to rise significantly. The problem with the naughties, is not so much that interest rates were cut in early 2000, but, the Fed was too slow to put up interest rates when there was a sign of a real recovery and boom in asset prices.

See: Taylor Rule and Interest rates

Also, of course, there was much more to the boom and bust than just interest rates.

Related

• Boom and Bust in US housing Market
• Boom and Bust economic cycles
  

With temperatures plunging to -20 degrees in Benson (just a few miles from Oxford where I live) this is becoming the coldest winter since, well at least, since the start of global warming.



For those with long memories they may remember the great winters of 1947 and 1963.

In 1947, the economic situation was different though with some interesting parallels. It was a time when public sector debt was over 200% of GDP (making our current situation of 60% look relatively not too bad). It was also an age of austerity - rationing and frugal spending habits were the order of the day.

Last year, one of the most notable changes in the economy was the rise in the savings ratio and the new habit of paying back debt - rather than taking more on. In a way we could talk of a new era of frugality - but even so, it's a frugality which has led to record sales for Sainsbury's, Tescos and other big retailers. It's a frugality which still saw a record 2 million new cars registered in the UK during 2009.

So although, we are saving more some habits die hard, which is probably a good thing given we need a relatively strong consumer sector to maintain economic growth.

How Much Can Snow Affect the Economy?

I don't have to hand any report which investigated the impact on economic growth of an economy impacted by unexpectedly bad weather.

Anecdotal evidence suggests that business was very quiet yesterday and is slowly picking up today. If transport difficulties continue, retailers could see a real hit to their revenue this week.

Some spending will be merely delayed until the weather improves. But, in this kind of shock, output will be lost as production is partly halted and spending limited.

If it is just a week of bad weather the overall impact on the economy will be limited, but, if weather problems were to continue for a month, it would start to be much more serious. It would be the last thing the economy needs at the moment.

Related

Supply of Salt

There are some grounds for optimism in the forthcoming year. Hopefully, the corner has been turned. But, nevertheless there are still many serious problems facing economies around the world.

Chinese Mercantilism

China has a policy of artificially keeping the Yuan undervalued. It does this through exchange controls and purchasing large sums of dollar assets. This weak Chinese Yuan is good for Chinese exporters, but, it creates disequilibrium in the world economy. It leads to a large trade surplus for China and a deficit for the US. The weak Yuan harms global demand, especially in the US. If the Yuan appreciated to its natural level, Chinese consumers could buy more imports and US companies would have greater competitiveness in selling to China.

Paul Krugman estimates the undervalued Yuan could cost the US 1.3 million jobs in 2010. (macro effects of Chinese mercantilism)

Also, this undervalued Yuan is a form of 'beggar thy neighbour' protectionism. It leads to retaliation in the form of protectionism against Chinese imports.

Weakness of Domestic Growth

Past growth was based on rising asset prices (especially housing) and a credit bubble. Neither of these is likely to return. Consumers are much more reluctant to spend, we are entering a new era of frugality with higher saving ratios. This has definite benefits but makes a recovery to normal growth more difficult.

False Dawns.

The global economy has suffered its worst years since the great depression of the 1930s. A small improvement in growth could cause a premature celebration of recovery - leading to the removal of expansionary fiscal and monetary policy which could cause a double dip recession.

Budget Deficits

The precipitous falls in economic outpur has compounded structural deficits leaving many countries facing record peace-time debt levels. Already some countries like Greece have already had rating downgrades. Others like the UK and Ireland have been threatened with rating downgrades. The need to offer concrete plans to reduce borrowing makes it a difficult balancing act for maintaining economic recovery.

Financial Weakness

Many banks and financial institutions are still nursing large losses from the credit crunch. It will take time for banks to improve their balance sheets. The prospect of further falls in house prices could still undermine banks fragile bank balance sheets.

Commodity Inflation

Whilst the fundamental problem is still spare capacity and unemployment, evidence suggest commodity prices are already rising due to strong Chinese and Indian demand. Rising oil prices could cause a return of cost push inflation we saw at the start of 2008. This could complicate Monetary policy which is trying to boost growth.

Firstly welcome back after Christmas break.

Readers Question: According to this graph the value of the dollar fluctuated significantly prior to the establishment of the Fed and then steadily declined way past any previous low levels. According to this (An exposition of the principles of modern monetary science in their relation to the national economy and the banking system of the United States 76th Congress, 1st Session, Senate Document 23), a primary reason for this institution was to help alleviate the wild swings in the value of the US currency. But, why then has the value of the dollar only declined since the existence of the Federal Reserve System? Is this not evidence as Ron Paul suggests, that the Fed should be stripped of it’s power?

A stable exchange rate can be one function of a Central Bank. But, arguably, it is less important than other objectives such as:

• Economic growth, aiming for full employment, increasing living standards, and ensuring all benefit from the proceeds of growth.

The Federal Reserve state their objectives include:

To manage the nation's money supply through monetary policy to achieve the sometimes-conflicting goals of:
• maximum employment
• stable prices, including prevention of either inflation or deflation
• moderate long-term interest rates
Objectives of Federal Reserve

Since 1913, the Pound Sterling has depreciated more than the dollar. But, a depreciating currency doesn't mean necessarily that living standards are falling.

At certain times, a falling exchange rate can be beneficial. Recovery from the Great Depression was quicker amongst countries who removed themselves from the Gold Standard.

If the Federal Reserve had responded to this crisis 2007-09 by trying to maintain a stable dollar, it would have been the worst possible mistake. What is the point of increasing interest rates to maintain a strong dollar, if it exacerbates the great recession and leads to higher unemployment?

Amongst some commentators there is a great fear of inflation. The idea is that the government is making people less wealthy by reducing the purchasing power of currency. But, this hasn't happened. Real interest rates have been mostly positive. Since 1913, living standards have improved in the US. By purchasing power parity, GDP per capita is the second highest in the world. Using the Economist index, US has the 13th highest standard of living.

The real problems (in my opinion) facing US are:

• Lack of Financial regulation which created recent crisis.
• Declining real wages in past two decades (according to Working Life US)
• Increased gap between rich and poor.
• Lack of universal welfare state.

The decline in the dollar is the least of America's problems. - a reflection of changing relative economy sizes.

I do admire Ron Paul for his belief's in civil rights / not invading other countries, not torturing e.t.c. But, as an economist he worries about the wrong things.

See also: Austrian economics for more on these issues

Related

• Dollar as global reserve currency
• Demise of the dollar
• Why is Federal Reserve buying securities
  

See part 1: Economics of the Naughties

Financial Markets need regulating.

Financial deregulation has been a disaster. Unchecked, the credit crisis shows that financial institutions can make basic mistakes in the pursuit of risky profit. Supporters of the free market have vainly tried to show the irresponsible loans of the naughties was actually due to government pressure. But, this is misleading, it was unregulated financial companies who made the vast majority of loans that had no chance of being repaid. There was a complete failure to adequately measure the level of risk involved in the buying of subprime loans. Somehow many of the NINJA mortgages (no income, no job) were rebundled, repacked and bundled as triple AAA credit rating. Western banks took these mortgages on, and it was the taxpayer who had to bailout their mistakes. Many banks pursued risky strategies of reducing liquidity ratios. There was a temptation to achieve short term profits by borrowing short to lend long. Northern Rock was once proud of it 125% mortgages. But, when the credit crisis hit, they were left unable to finance its positions. It was only when credit markets froze that they realised their business structure was flawed.

The Problem of Moral Hazard

A real problem we have is that banks acted on a premise of invulnerability. As we mentioned in this post, bankers often have an incentive to pursue risk. (problem of bank bonuses) Heads they win - tail the taxpayers lose. This is still a pressing issue - how to balance the need to ensure banking stability and prevent bank runs, without giving bankers a green light to pursue the most irresponsible strategy - knowing if they mess up someone else will clean it up.

One Tool Does Not fit

In the middle of the 2000s, it seemed that interest rates were the magic wand of the central bank to achieve any economic goal they wanted. Alas, this is not the case. Managing the economy is much more difficult that just changing interest rates. An interest rate cannot maintain strong growth, target inflation, and target asset bubbles all at the same time.

Keynesian economics

At the start of the recession, interest rates were slashed from 5% to 0%, without effect. We were in a liquidity trap where rate cuts may have no effect. In a liquidity trap, there is need for more - expansionary fiscal policy, quantitative easing. Faced with the failure of markets and the prospect of another Great Depression. The analysis of Keynes from the 1930s became very important.

Government Borrowing is necessary in a recession

One of the difficult things has been to explain, though government borrowing is bad, it would be even worse to try and reduce borrowing in the middle of a recession.

A boom is a time to reduce deficits.

Hindsight is a wonderful thing. But, at the height of the boom the decision to increase government borrowing was a painful mistake. America cut taxes and increased military spending. The UK increased spending on social security and health care. This meant both had large deficits before the recession started. This reduced room for maneouvre when the recession came.

Inflation Target can be Misleading

The central policy target of both UK and US was low inflation. With low inflation, neither governments could believe they were in the middle of an unsustainable boom. The low inflation rate, masked a boom in asset prices caused by unsustainable lending. A stable economy doesn't just need low inflation it needs stable asset prices, and sustainable bank lending.

Related

• Lessons from Great Depression
• What can we learn from financial crisis?