Impact of global economy on UK inflation

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Readers Question: I am currently researching the impact of the global economy on inflation in the UK. I have come across economic policy uncertainty but am unsure what effect policy uncertainty in the EU and USA will have on the UK.

cpi-inflation

UK inflation is primarily due to domestic factors. For example, if you look at the inflation of the early 1990s, it was due to an economic boom and rapid growth in aggregate demand. This level of inflation wasn’t experienced by our main international competitors.

In 2011, the UK experienced higher rates of inflation than the Eurozone and the US. The reason inflation was higher in the UK than the Eurozone was due to factors such as:

  • Impact of devaluation causing imported inflation.
  • Rise in taxes. CPIY (a measure of inflation excluding taxes) was much lower than the headline CPI rate
  • Rise in commodity prices having a greater impact in the UK.

Global factors affecting UK inflation

There are still global factors affecting UK inflation. Firstly, the price of commodities, such as oil, metals, food will affect UK inflation. The rise in oil prices in 2008 and later in 2011/12 was a factor in causing UK inflation.

Global trends in inflation. Since the 1970s, inflation in advanced industrial countries has fallen. This global trend towards lower inflation has helped the UK also experience lower inflation. Lower inflation across the globe is due to several factors, such as:

  • Rising productivity and cheap manufactured goods from China / Asia.
  • Improved technology and working practices which have helped reduce costs.
  • Perhaps inflation targeting. e.g. Monetary policy geared towards keeping inflation low.
  • Decreased inflation expectations making it easier to keep inflation low.

The UK has definitely benefited from these global inflationary trends. But, at the same time, domestic factors have been influential in affecting UK inflation. Currently, Eurozone inflation has fallen to 1.1% but UK inflation is higher at 2.7%

What will be the effect of policy uncertainty in the USA  on the UK?

There is significant policy uncertainty in the US, with the government shut down. A prolonged debate about US government spending could risk precipitating a downturn in the US economy and an end to the US economies reasonable recovery. This would be highly damaging to the global economy. If the US economy falters, it will definitely have a negative impact on economic growth elsewhere in the world. There is also the risk of adversely affecting confidence in countries like UK and Europe.

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Global warming and tax cuts on petrol

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The other day, I had a quick glance at the newspaper headlines, whilst in a service station.

  1. UN Report on global warming states global warming is a real threat to the future of the planet. To contain these changes will require “substantial and sustained reductions of greenhouse gas emissions”.
  2. Chancellor announces yet more freezes on fuel duty.

It seemed a paradox to have both headlines on the same day. At the very least, we could enable a small increase in tax on fossil fuels causing the problem.

sea-morecambe-bay
Rising sea levels will be more damaging that a few pence on the price of petrol

Costs of global warming

In the summary of the UN document on global warming.

  • The report states that for a doubling of CO2 in the atmosphere, the increase in the global temperature is forecast is to be 1.5C to 4.5C.
  • The scientists say that sea level rise will proceed at a faster rate than we have experienced over the past 40 years. Waters are expected to rise, the document says, by between 26cm (at the low end) and 82cm (at the high end), depending on the greenhouse emissions path this century. (BBC link)

Political benefits of tax cuts

The chancellor has announced more freezes on fuel duty because it believes it will be politically popular. He is probably guessing that concern over the cost of petrol is greater than concern over the future of the planet.

Tragedy of the Commons

This situation could be classed as a classic example of the tragedy of the commons. People pursuing their self-interest but ignoring the common shared resources – leads to a loss in economic welfare. The problem is that with many individuals maximising their short-term welfare, there is a high cost to the future sustainability of the common resource.

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US housing market main cause of credit crunch

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Readers Question: The money that brokers/banks etc were making from selling on the mortgages to investors encouraged the sub prime debacle. Which I understand. The bit I am struggling with is what started the fall in the US housing market. If the banks slowed down on their lending that would surely just cause a slow down in new mortgages which would result in a slow down in the housing market.

It was in the US housing market that the real problems emerged. It was mortgage defaults that caused the biggest hole in bank balance sheets.

In the boom period, mortgage lending had been very aggressive. Mortgage companies made new mortgages to

  • People with bad credit,
  • Mortgages with high income multiples,
  • Mortgages with low introductory offers – low interest rates for the first year, then rising interest rates.

Basically, people were being given mortgages, who in ordinary circumstances wouldn’t be able to afford their mortgage payments. A fundamental problem was the lack of satisfactory regulation in the mortgage market. It was kind of hoped US housing prices would keep rising so that if people couldn’t afford mortgage payments the house could just be sold.

However, when US interest rates rose in 2005 and 2006, many US homeowners started to default on their mortgage payments, and homes began to be repossessed; as a result, banks lost money. Mortgage defaults also spread across the financial system because these mortgage debts has been repackaged (sold on) to other banks.

This is when the credit crunch really started to occur, banks balance sheets were adversely affected by mortgage defaults of US homeowners. Because banks and other financial institutions lost money, they also had to cut back on lending. This led to fewer people buying houses and caused an even bigger drop in house prices. As house prices fell, banks lost more money on mortgage defaults.

See also: Boom and bust in US housing market

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Bank loans and reserve ratios

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Readers Question: I have a question on the credit crunch – if banks are operating fractional reserve banking then why would they cut back on lending to businesses as every loan increases their money reserves? Surely they would only suffer a shortage of credit if they reduced their lending so they are in effect cutting …

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The case for austerity

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I’m currently writing a 2,500 word essay on ‘UK Austerity’ for the magazine Economic Review. I think the idea of these magazine articles is to present a ‘balanced view’ so I’ve been looking up the case for austerity as well as the case against. As far as I can see the economic rationale for austerity includes some or all of the following:

1. Rising bond yields. Starting with Greece, several Eurozone economies faced sharply rising bond yields in the period 2009-12. Investors were no longer confident in the ability of European countries to repay government debt or at least stay liquid. Therefore, they demanded higher bond yields in compensation for the increased perceived risk.

eu-bond-yields-7-countries

Rising bond yields were taken as a sign that debt levels were too high and unsustainable. Therefore, to reassure bond markets, governments pursued austerity / spending cuts to reduce budget deficits and hopefully reduce bond yields.

In the case of the UK, the government argued that if Greece, Ireland and Italy could all have rising bond yields, the same could happen to UK bonds. If government bond yields did rise, the government argued it would have many adverse consequences for the economy:

  • Increase cost of debt interest payments.
  • Make it difficult to sell sufficient bonds to cover the large budget deficit.
  • Rising bond yields can create a knock on panic to other bond investors. The nervousness was potentially contagious.

2. Crowding in.  There is a view that if the government reduces spending and reduces government borrowing, then this enables a growth in the private sector. The argument is that government borrowing restricts private sector investment because when the government borrows it takes money which could be used to finance private sector investment.

3. ‘Expansionary austerity’ This was a view offered at the start of the crisis. The argument is that uncertainty over rising bond yields was holding back private sector investment. If the government pursued austerity and proved to the market it was serious about reducing the deficit and bond yields, markets would be more confident about the future. The sound money of the government would encourage private sector investment and higher economic growth.

4. State is too big. Mixed up in the case for austerity is the more general argument that state spending had got too big. The recession was seen as a good time to cut away inefficient government spending. In particular, some economists were critical of the bloated size of the welfare state and pension commitments.  Often critics of Keynesian economics argue that if you pursue temporary spending to boost demand, this temporary stimulus ends up being permanent, due to special interest groups. Instead, the opposite should occur, and governments should take the opportunity to cut spending.

 

5. Debt is too high. The credit crunch was caused by banks taking on too many ‘bad’ debts. Because the excess accumulation of  private sector debt caused the credit crunch and recession, it was easy for governments to make a link that we need to tighten belts and reduce government debt burdens.

EU debt levels debt / GDP % 2007 – 2010

debt

e.g. Ireland debt to GDP ratio rose from 27% to 97% between 2007 and 2010

In the great recession, budget deficits did rise rapidly because of the  fall in tax revenues due to recession, rise in welfare spending due to unemployment, and bailing out banks.

One influential paper (2010) by Carmen Reinhart, now a professor at Harvard Kennedy School, and Kenneth Rogoff, an economist at Harvard University, suggested that when debt / GDP  levels rose above 90%, then it leads to significantly lower economic growth. (90% question at Economist) Therefore, this provided an argument for tackling government debt.

6. Countries with austerity have had positive growth

Every country which pursues austerity has at some time seen economic recovery. Latvia experienced a strong recovery (after very sharp fall in GDP during the recession.) Now positive growth in UK is seen as vindication of austerity.

Criticism of Austerity

A quick evaluation to these points

1. Rising bond yields. The assumption was that rising bond yields were due to high levels of debt. But, with perhaps the exception of Greece, rising bond yields were primarily due to having no Central Bank willing to act as lender of last resort. Evidence for this comes from:

  • Countries like US and UK with very large budget deficits saw falling bond yields during the recession. These countries had own currency and Central Bank willing to ensure liquidity.
  • In 2012, when the ECB finally became willing to buy unlimited bonds, bond yields fell sharply.
  • Austerity policies often caused bond yields to rise because markets feared falling GDP would make debt levels more unmanageable.

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EU success or crisis?

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The German Finance Minister Wolgang Schauble has been a strong advocate of austerity, supply side reforms and ‘sound money’ policies. (i.e. sticking rigidly to inflation targets). Generally, this has been the preferred approach of Europe to the ongoing debt crisis and recession of the past few years. Recently, he has claimed that the European economy is recovering well and this is vindication that the broad approach of fiscal discipline and structural reforms are laying a foundation for strong economic growth in the future.

Writing in the Financial Times, Schauble states:

While the crisis continues to reverberate, the eurozone is clearly on the mend both structurally and cyclically.

What is happening turns out to be pretty much what the proponents of Europe’s cool-headed crisis management predicted. The fiscal and structural repair work is paying off, laying the foundations for sustainable growth. This has taken critical observers aback. It should not have, because, in truth, we have seen it all before, many times and in many places. Despite what the critics of the European crisis management would have us believe, we live in the real world, not in a parallel universe where well-established economic principles no longer apply. (FT – Ignore the doomsayers)

Others are much more critical arguing that this view ignores the long-term damage being done to the EU economy by years of deflationary policies. Also, his view ignores the damage of self-defeating austerity which has caused mass unemployment across Europe and rising debt to GDP ratios.

Economic recovery in Europe

EU growth

source: Eurostat

Firstly, the recovery is very timid. The Euro area did grow by 0.3% in the Q2 of 2013, but Eurozone real GDP is still -0.5% lower than 12 months ago. The important point is that since 2008, Europe has failed to reach a normal rate of economic growth – there has been no escape velocity. The recovery of 2010 petered out.

Reasons to hold back on the champagne and not celebrate the EU economy.

1. Quarterly growth figures are very limited in determining the success or otherwise of the economy. The European recession began in 2008. The fact you have one quarter of positive growth in 2013 Q2 doesn’t overcome the five years of recession. Real GDP growth has fallen drastically behind the trend rate of growth necessary to get anywhere close to full capacity.

2. Unemployment. Unemployment is arguably the most useful statistic for understanding the degree of spare capacity and wasted resources in an economy. High unemployment has very high social costs in terms of lower incomes, declining morale, and wider social problems. On this metric, the Eurozone faces an unprecedented crisis. Yet, it tends to be brushed aside by European policy makers.

Eurozone-unemployment

New site and new shop

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In the past few weeks, I’ve been working on a new version of the site. I’ve imported some pages from original ‘dreamweaver’ static site and have introduced a new shop for buying products. This shop uses WordPress, Woo commerce. You will be able to buy revision guides using a basket and cart. The home page …

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