Why was inflation higher in the 1970s?

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Readers Question: Why was inflation higher in the 1970s? In 2022, inflation has increased in western Europe to the highest levels for many years. With inflation in UK and US approaching 10%. Yet, despite rising oil prices and other inflationary pressures, inflation is still considerably lower than in the 1970s. A big question is whether …

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How important is the budget deficit?

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Readers Question: How important is the budget deficit?

The budget deficit is the annual amount the government borrow. The government usually financed the budget deficit by selling bonds to the private sector

To libertarian and free-market economists, budget deficits are liable to cause significant economic problems – crowding out of the private sector, higher interest rates, future tax rises and even potential for inflation. However, Keynesian economists are more sanguine arguing that in an economic downturn, a budget deficit plays an important role in stabilising economic growth and limiting the rise in unemployment.

Budget deficits have potential economic costs, but it depends on the economic climate, the exchange rate system, interest rates and the reason for government borrowing.

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OECD – Budget deficits 2012

The most useful way of measuring the size of the budget deficit is as a % of GDP.  The graph below shows that in 2012, there was a large variance in the size of budget deficits. The biggest deficits occurred in Ireland, Japan, UK, and US – with budget deficits of over 8% of GDP.

Potential benefits and costs of a budget deficit

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Reasons to be concerned about a budget deficit

  • Need to cut spending in the future. Higher deficits are not sustainable forever. Reducing a budget deficit can be problematic. If a country has a deficit that increases too quickly, the government may be forced to adapt policies aimed at a sharp deficit reduction. These ‘austerity measures’ can cause a fall in aggregate demand. For example, during 2012-16, many countries in the Eurozone sought to reduce their budget deficit to comply with EU rules. This deficit reduction caused lower growth, recession and unemployment.
  • Increasing national debt. A budget deficit increases the level of public sector debt. Large deficits will cause national debt as a % of GDP to increase.
  • Opportunity cost of debt interest payments. A higher deficit will also lead to a higher % of national income being spent on debt interest payments.
  • Crowding out. One way of thinking about a budget deficit is that if the government is borrowing from the private sector, the private sector has lower funds to spend and invest. The government is, therefore ‘crowding out’ the private sector – and some economists will argue government spending is liable to be more inefficient than the private sector.
  • Potential rise in bond yields. Countries with large deficits may struggle to attract sufficient investors to buy bonds. If this happens, bond yields will rise causing the deficit to be more expensive to finance.
  • Potential inflation. There is a fear that budget deficits could be inflationary. For example, if a country like the UK was struggling to attract sufficient investors to buy UK bonds, the Central Bank could effectively print money and buy bonds. However, unless the economy is in a liquidity trap, printing money will cause inflation, and reduce the value of savings, including government bonds. It is worth pointing out, that in developed economies – inflation from printing money resulting from a budget deficit is quite rare.
  • Confidence effects. High levels of government borrowing may adversely affect confidence as consumers and firms fear future tax rises or higher interest rates.

Evaluation

There is no simple answer to whether a budget deficit is helpful or harmful because it depends on quite a few factors.

1. It depends on when the deficit occurs. Basic Keynesian analysis suggests that a rise in the budget deficit during a recession is a good thing. In a recession, private sector spending falls and saving rises – leading to unused resources. Government borrowing is a way of utilising these unused savings and ‘kickstarting’ the economy. The deficit spending can help promote higher growth, which will enable higher tax revenues and the deficit will fall over time. If you try to balance the budget in a recession, you can make the recession deeper. Austerity can be self-defeating.

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Investment in UK – Business and Public Sector

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Source: ONS NPEN

Total UK Business investment since 1997. After sharp fall in 2009 due to global recession, investment recovered quite strongly. In 2016, Investment fell, at least in part, due to the uncertainty of the Brexit vote and leaving the Single Market. The covid pandemic caused another sharp fall in investment.

The poor investment performance is concerning for the UK economy as it is reflected in poor productivity growth, low economic growth and limited real wage growth

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UK real GDP has never recovered its pre-2007 trend rate of growth.

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The poor levels of investment post 2008 are reflected in poor labour productivity growth.

Investment in profile

From 2007 to 2010 we see a 22% fall in private sector business investment. This was the result of

  • Banking crisis – banks didn’t want to lend
  • Fall in consumer confidence
  • Recession, which caused firms to hold bank from investment

Recovery in business investment since 2010

  • From a low basis and 20% fall
  • Helped by low interest rates making investment more attractive, but availability of funds a bigger problem than the cost of borrowing.
  • Business investment has fallen behind past trend growth in value of business investment.
  • Still volatile and uncertain, e.g falls in 2014 and the end of 2015

Factors influencing future investment levels

  • Despite low interest rates, banks are maintaining strict lending criteria and rationing finance. Many small and medium sized firms still state finance is difficult to come by.
  • Prospects for economic recovery are poor. The Bank of England’s latest inflation report painted a gloomy picture of an economy struggling to post positive economic growth.
  • Fall in inflation rate and possible deflationary pressures
  • Uncertainties over Britain’s place in Europe.
  • Euro-zone debt crisis and EU recession also weigh heavily on UK investment decisions.
  • Future of interest rates. Will interest rates rise to increase the cost of borrowing.

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To what extent did Covid cause inflation?

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There is no doubt that as the economy emerged from Covid lockdowns in 2021, the world experienced a surge in inflation, not seen since the 1970s. There are many supply and demand factors, which have caused this unexpectedly high inflation. The first factor is that Covid lockdowns, especially in China and Asia, disrupted global supply …

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Why would Pound Sterling fall after Brexit?

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22 June 2016 If the UK vote to leave the EU, many predict the Pound will fall significantly. Investor George Soros predicted it could be a bigger fall than in 1992 ERM crisis. Soros claims the Pound could fall by up to 20% (BBC) There are different reasons why the Pound may fall. Uncertainty. Leaving …

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Reasons for net migration into the UK

The latest stats for UK net migration show annual net migration of 239,000 (Q1 2022). This used to be roughly split between EU and non-EU migrants. But, since Brexit, there has been a big change with 437,000 immigrants from Non-Eu and 195,000 from the EU.

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  • In Q1 of 2020, there were 437,000 annual immigration from Non-EU countries and 195,000 from EU Countries
  • Net migration of EU is now close to zero, with just 58,000, compared to 316,000+ from outside EU.

Reasons for migration into the UK

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  • According to data by the ONS, the biggest reason for net migration into the UK is to pursue education studies. This accounts for 257,000 (Nov. 2014)
  • The second biggest reason is work related 228,000
  • The third biggest reason is to join family already living in UK or accompany partner moving to UK – 70,000
  • Other reasons 13,000 includes vague responses, such as ‘coming back to live’

Asylum seekers

  • 14,734 people were granted asylum in 2021

Reasons for migration depend on country of origin

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Source: ONS migration

 

  • For recent arrivals (2007-11) study is one of main reasons for migration.
  • Employment and unemployment rates for UK citizens and EU migrants are very similar.

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The relationship between oil prices and inflation

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Oil prices have a significant effect on the consumer price index, though the correlation between oil prices and inflation is less direct than it used to be in the 1970s. St Louis Fed estimates a correlation of 0.27 between changes in the oil price and inflation. In other words, a sustained 10% rise in oil …

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UK Budget Deficit

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  • The budget deficit is the annual amount the government has to borrow to meet the shortfall between current receipts (tax) and government spending.
  • Net borrowing for the UK 2021/11 is £151.8bn or 14.8% of GDP [OBR – J511]
  • National debt or public sector net debt –  is the total amount the government owes – accumulated over many years. See: UK national debt (May, 2022 – £2,347.7 billion equivalent to 95.% of GDP)

UK Borrowing

Budget deficit – annual borrowing

This is the amount the government has to borrow per year.

  • In 2000/01, the UK ran a budget surplus of £17bn or 1.7% of GDP
  • In 2009/10 at the height of the great recession net borrowing was £152 bn or 10% of GDP
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UK net borrowing

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View:  Latest statistics at OBR

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